In the early 1990s, the failure of BCCI and Robert Maxwell’s fraud at the Mirror Group led to the writing of the Cadbury Report in the UK, which provided best practice recommendations for boards of public companies and their corporate governance
In the alternative investment funds world, if professionals, promoters and investors are honest, one or two relatively high profile cases aside, there was little genuine focus on governance prior to the start of the financial crisis in 2008. However, guidance from industry bodies had been around for years prior to that and in 2008, by coincidence, the Alternative Investment Management Association published their own best practice guide
This article will explain the history of governance for Cayman Islands investment funds, how the industry fared during the financial crisis at a time when governance structures were held up to their most intimate scrutiny for some years, deal with the fallout of the Weavering case, about which so much has been written in the last 12 months and then focus on how the industry has evolved and continues to evolve to address concerns of promoters, fund professionals, regulators and, perhaps most importantly, investors.
I will expand on the reason why the term ‘corporate governance’ is now not sufficient, as investors and fund professionals seek to implement governance structures into Cayman Islands limited partnerships and also onshore vehicles such as Delaware limited liability companies and limited partnerships. The type of governance model now required by investors and fund professionals is not limited to the role of directors of a corporate fund but is, and must be, part of a broader ‘fund governance’ approach.
Finally, this article will consider whether or not there comes a tipping point where the governance tail begins to wag the performance dog.
Fund Governance
While limited partnerships, trusts and companies have all been used to create registered funds in the Cayman Islands, it is fair to say that the corporate model has been the most popular; this is because at the inception of the financial services industry in the Cayman Islands, the corporate vehicle and its constitutional documents were the most familiar to industry professionals and also due to the attractiveness of tax efficient deferred fee earning arrangements, made possible by corporate vehicles, to US-based fund managers.
As in other jurisdictions, the management of a company incorporated in the Cayman Islands vests in its directors. Historically, investors may not have had fund governance and the identity and role of directors of corporate funds uppermost in their minds when making their investment decisions. Rather, their sole focus was on the identity and track record of the manager. The Cayman Islands has never placed any limitations on residency, age or qualifications of directors. Instead, for many years, the industry “self-regulated”, in that, if an investor was unhappy with the performance of management, they could vote with their feet and take their investment dollars down the street. As a result, the requirement by investors for directors of investment funds to review critically the performance of a particular manager was fairly limited.
Things changed at the end of 2008. Whereas previously a fund’s power to suspend its investors’ right to redeem their investment was a power that existed but was rarely used, the sudden lack of liquidity in fund investments meant that it started to be used for the first time. Suspensions meant that investors were unable to take their cash out until the circumstances that gave rise to the suspension had ceased to exist, i.e. liquidity of the funds improved, or at all in the most extreme cases.
At this point, investors realised, perhaps for the first time, the important role played by fund directors to act in their interests when supervising the way in which the manager attempted to extricate the fund from the situation in which it found itself. In particular, where a manager continued to charge and be paid fees to manage the assets, someone needed to be responsible for overseeing, and being critical of, the manager’s performance.
Typical fund boards were made up of representatives of the investment manager, retired lawyers or accountants, employees of the administrator or the fund’s lawyers and sometimes a mix of all three. However, if the directors were also the principals of the investment manager, in whose interests would they really be acting?
Investors began to call for conflicts of interest to be managed appropriately. Consequently, although the principles of fund governance are not new, over the past few years we have seen a gradual change in industry practice and expectation. It has become no longer sufficient to pay lip service to governance and investors are increasingly requiring and expecting robust fund governance models, akin to those seen in onshore public companies, and these new standards are considered in further detail below. Existing principles and practices have been re-examined; so it is appropriate re-examine them here.
The Cayman Islands legal framework governing duties of care owed by directors is rooted in long-standing principles of English common law and equity, established by case law in the English courts. The duties of directors fall into two broad groups: duties of loyalty, honesty and good faith (known as fiduciary duties) which include a duty to manage conflicts if interest, and duties of care, skill and diligence. These duties include a broad responsibility to ensure governance mechanisms are in place and an obligation to act in the best interests of the fund.
It is important to note that these duties of care are owed to the company rather than to individual shareholders or investors in a fund. In practice, this means that directors must, in the ordinary course, consider the interests of all shareholders or investors (as the embodiment of the “company”). Investors sometimes find this surprising; in particular, the requirement that a director may not take into consideration the interests of one majority shareholder, over and above the interests of all the investors taken as whole and furthermore, the fact that if the fund finds itself in financial difficulties, directors must also consider the interests of creditors.
The standard of care applied to directors has traditionally been partly an objective standard (the standard of the reasonable man) and partly subjective, in that the courts are likely expect a director to utilise his particular skills (e,g. of accountancy). This means a director who is also a representative of an investment manager, and therefore has specialist knowledge of the investment strategy of a fund, may be held to a higher standard.
A director must exercise reasonable care and diligence but is not liable for errors of judgment. Directors therefore can rely on opinions and advice of advisers but they must still exercise their business judgment based upon such advice.
Since all of these duties are owed to the company, any claims against the director must be brought by the company. Therefore, as was the case in Weavering, claims are usually pursued by the liquidator of a failed fund. In certain limited circumstances, the court may grant an aggrieved shareholder a derivative right to sue the director on behalf of the company, but this is rare.
What is Good Governance?
So, in light of this umbrella of somewhat abstract legal principles, what is considered good governance practice for a fund today and who is best placed to implement it?
We must consider, among other things, the facts and judgment in Weavering – the most prominent Cayman Islands case on this topic in recent years, that has provided industry professionals with an insight into how the courts would interpret traditional directors legal duties in the context of the Cayman Islands funds industry.
It was a case of extreme facts: the fund’s investment manager (Magnus Peterson) arranged the appointment of his younger brother and elderly stepfather to serve as the fund’s directors on a gratuitous basis, merely to meet minimum legal requirements rather than to form a real board of directors. For the next 6 years, they did nothing to discharge their functions as directors beyond signing any number of documents at the manager’s request, and even signed fictitious minutes of two board meetings which never took place. This semblance of corporate governance allowed the manager (while deceiving the directors and other service providers) to fraudulently inflate the fund’s NAV by booking fictitious interest rate swap transactions to disguise substantial losses which the fund was suffering. By the time this scheme was discovered and the fund was put into insolvent liquidation, over $141 million had been wrongly paid out to investors by way of redemptions based on NAVs which were artificially inflated to the tune of $111 million in aggregate. In these circumstances, it was easy for the court to find the directors guilty of wilful default – an essential finding, since it disqualified them from relying on an indemnity from the fund which would otherwise have blocked the liquidators’ claim.
Given these facts, it’s easy to see the worst of fund governance: directors signing documents without reading them, claiming to have held meetings when they have never been held, not reviewing or querying financial statements and not asking questions of the service providers to the fund. In fact, simply not taking the role seriously.
The judge in Weavering, was able to take these facts and use them as a platform to give his views as to what constitutes good governance. From his judgment, we have been able to discern practical steps directors could, and should, take to ensure adequate supervision, both at the establishment of the fund and for its duration.
During the establishment phase for a fund, promoters may wish consider who should sit on the fund board from a number of perspectives:
- What are prospective investors likely to expect or want? The manager may already have a seed investor lined up, so their views will be key.
- What actual or potential conflicts of interest will a particular director have? If there are any, can they be effectively dealt with or do they rule that director out altogether? For example, if the investors want a representative from the manager on the board (in some surveys up to 70% of hedge fund allocators expected a senior member from the investment manager to be on the board
3 Corporate Governance In Hedge Funds: Investor Survey 2011 (Carne Global Financial Services)
- Next is the question of whether the directors should genuinely understand the ins and outs of the trading strategy. Despite the potential for conflicts of interest, some investors may derive comfort from having a representative of the manager on the board who does have this understanding.
- Do the prospective directors have the right knowledge and experience and do they complement each other? Having three directors whose professional background is similar or identical might not be as beneficial as having three directors from different backgrounds.
- What other demands does the director have on their time? There has been much criticism of so-called ‘jumbo directors’ and corporate directors (ie directors which are companies rather than individuals). Their model is to have a staff of assistants to review and filter issues for their attention to allow them to sit on a large number of fund boards. The other end of the spectrum would be a sole practitioner who limits the number of board appointments to those that they can personally supervise and manage. There are no right or wrong approaches here, just different approaches.
Directors must satisfy themselves that the overall structure of the fund and the terms of service provider contracts (in particular those relating to the determination of NAV, remuneration, indemnification and limitation of liability) are reasonable and consistent with industry standards and to the extent that they are not, that there are reasonable reasons for the divergence. Where a fund structure or service provider agreement is not standard, this would be a matter for disclosure in the fund’s offering document.
Directors should find out what service providers will and will not be doing for the fund and ensure that delegation and the division of responsibilities is appropriate. For example, the directors should ensure that responsibility for calculating NAV, anti-money laundering compliance, maintaining accounts, preparing management accounts and preparing financial statements is split appropriately between the investment manager and the administrator.
Directors are responsible for the contents of the offering document of the fund. As such they should ensure that the offering document is accurate and not misleading on launch and on an ongoing basis. In the case of a Cayman Islands registered mutual fund, they should be satisfied that the offering document describes the equity interests in all material respects and provides such information as is necessary for an investor to make and informed decision on whether or not to purchase the equity interests
If an item has been delegated to a single director to approve, for example, a final draft of an agreement or the final draft of the offering document, there must be a process in place to circulate final documents to all of the board members and to note this at a subsequent meeting.
In essence, directors must perform a high level supervisory role. The very nature of an offshore hedge fund means that directors are non-executive and investment management, administration and accounting functions are delegated to third parties. This is acceptable, but in the words of the judge in Weavering, “they are not entitled to assume the posture of automatons”. Simply to sit back after delegation of a role to a service provider and assume it is being done properly is not acceptable. Directors are not absolved from performing their duties and must supervise the discharge of any delegated functions.
It seems trite to say that directors should hold regular board meetings, but many fund boards do not have formal timetables for regular meetings in place. Board meetings should be held sufficiently frequently so that the board is able to carry out its role effectively. The frequency of meetings will depend on the nature of the fund and the circumstances. If market or other conditions require it, directors should consider if an extraordinary meeting is necessary.
Agendas and underlying documents should be circulated before formal meetings with sufficient time for review of both. An agenda should reflect input from the investment manager, administrator, directors and any other relevant party.
Board minutes should be kept for all board meetings that are held. These should fairly and accurately record the matters which were considered and the decisions which were made. Discussions do not need to be recorded in detail, but should be summarised, at least to the extent necessary for the reader to understand the basis upon which the decisions were made.
Directors should keep evidence of enquiries made to service providers, such as emails or records of telephone conversations that take place outside of board meetings.
Directors should ensure that a minute book is kept and that copies at least are sent to Cayman counsel and the registered office in Cayman. For funds or directors based in some jurisdictions, to have the minute book offshore might be important from the tax perspective to avoid the fund’s management being ‘brought onshore’.
Directors are responsible for ensuring that the financial statements of the fund give a true and fair view of the fund’s state of affairs at the end of the year. This is not altered by any delegation of accounts preparation to the administrator or the investment manager.
The board should require regular reporting from the investment manager and other service providers such as the administrator. The reports from the investment manager will enable the directors to ensure that investments of the fund continue to be made within the relevant investment parameters and restrictions set out in the offering document and the investment management agreement. Reports from the administrator will allow the board to keep up to date with AML compliance, changes in pricing sources, pricing problems, deviation from standard procedures.
However, it’s not simply enough to concern themselves with financial reports, directors should be asking the broadest set of questions possible. For example, before Hurricane Sandy, how many boards would have quizzed managers or administrators about disaster recovery protocols? Something that is standard in the Caribbean, but perhaps not so much in New York!
Directors should find out how the audit is carried out and what the timing is. All registered funds have at least six months from their financial year end to finalise their audited financial statements and to file them with the Cayman Islands Monetary Authority. They must be provided in plenty of time for the directors to review them and ask any relevant questions. For a fund of funds, for example, this is particularly important because it might not be possible to finalise the audit until very late in the six-month period.
The sticky question of side letters is often a source of concern for boards and managers alike. As the promoter of the fund, the manager will want carte blanche to be able to agree terms with new or prospective investors. However, are the terms being offered even within the gift of the manager? Is it appropriate for a board to delegate certain powers to a manager to negotiate on their behalf or should they be involved? If the fund is a party or undertaking to carry out certain actions, then the directors should review them and be comfortable with their terms from a commercial and legal perspective. For example, if the side letter imposes extra investment restrictions, are these appropriate for the fund and its investors as whole and does agreeing to them impact on the rest of the strategy as reported to investors? It is not enough simply to know that side letters may be entered into by the fund. If the investment manager has been given delegated authority to negotiate and execute side letters on behalf of the fund, this should form part of the regular reporting to the board and the scope of such authority should be agreed.
Isn’t this all obvious though? Common sense? Some investor representatives would say not. Investors were shaken by the liquidity crisis of recent years and the resultant inability to redeem their investments. Both the Universities Superannuation Scheme Limited in the UK and Mesirow Advanced Strategies, Inc., in the US are vocal proponents of a movement pushing for a better model for fund governance in alternative investment structures. It is clear that there is increasing appetite from investors for an activist fund investment model.
As far as both the investors and the courts are now concerned, it is no longer sufficient to put in place the appearance of fund governance, but then to do nothing, to not ‘walk the walk’. Directors are now expected by investors to be inquisitive and critical, as opposed to simply rubber stamping proposals given to them by the investment manager. They are expected to ask the difficult questions. They are expected to ask broader questions. Scrutinising financial performance is, and always has been, essential, but they also need to review staff turnover at advisers (particularly the manager), IT systems, disaster recovery etc. – to have a grasp of the detail. As competition for managers to attract institutional money to their funds increases, governance has become, and will continue to be, a key selling point.
Good independent director service providers are already doing all of this but the future may see more fund boards made up of directors who are independent of all service providers and maybe even independent of each other, with such a structure becoming the norm rather than the gold standard.
An interesting related issue, is whether or not there are enough providers of independent director services to service the demand that has been created? If investors are beginning to require funds to act more like public companies, will directors be asked to retire by rotation and be re-appointed by investors? In light of this, criticism of jumbo-directors simply based on a numbers game might not stand up to scrutiny provided that those directors are working within a well staffed and structured organisation; while, at the same time, it is likely that there will be more entrants to this market offering a more traditional non-executive sole director model.
Will directors expect increased protection to reflect the increased scrutiny of their functions? Some may say that these are all things that they should have already been doing so it would be hard to justify increased annual fees. However, directors are often among the lowest paid of all service providers to the fund with arguably the most potential liability, so should they be expected to provide this enhanced level of governance without being suitably rewarded?
Good governance and institutional investor requirements may well also include a requirement that a fund have D&O insurance in place. If things go wrong, directors of corporate funds will inevitably seek to rely on indemnities from the fund which are either contained in their services agreement or incorporated by reference from the fund’s Articles into their engagement contract. The last thing that an investor wants is for a manager to have to liquidate fund positions in order to pay out under the director indemnities. Equally, though, there are some managers who will not appoint directors who insist on D&O cover.
In fact, in Weavering, part of the reason the liquidator of the fund brought the action against the directors was in order to obtain a pay out under their D&O insurance and this may have been one reason why allegations of fraud were not brought against the directors, as fraud may often be excluded under a D&O insurance policy.
What Does the Future Hold?
It’s not possible to say with any certainty what the future of fund governance holds. Is some form of regulation inevitable? Will it help?
In the Cayman Islands, alternative funds aimed at sophisticated investors make up more than 95% of registered mutual funds. Perhaps these sophisticated investors are the people best placed to drive change? At the recent Cayman Alternative Investment Summit, the buzz word was ‘institutionalism’ with a focus on governance. Whereas previously governance requirements may have been the preserve of institutional investors, it would appear this is now trickling down to managers, who are realising that genuine independent fund governance is the model that all, and not just some, investors are demanding.
One example of this is new governance models that are being introduced to master/feeder structures. In a master feeder structure, from a governance perspective, until recently the main focus of investors, fund professionals and promoters was at the feeder fund level.
However, where are the assets once the ‘fund’ is up and running?
A typical Cayman Islands fund structure may involve a Cayman Islands feeder company, an onshore feeder (which is may be a Delaware limited liability company) and a Cayman Islands master fund, which may be either a company or a limited partnership.
The promoter may put in place an independent board of directors on the offshore feeder but in most cases, the promoter serves as the general partner or managing member of the onshore feeder. Which approach is taken at the master fund level? If the master fund is also a Cayman Islands company then invariably the same board will sit at the master fund level. So far, so good, as far as governance at the asset level is concerned. But what if the master fund is a partnership? Traditionally, the general partner of the offshore master partnership has almost always been the investment manager or a special purpose company under the control of the investment manager.
The fact that there may be a board of directors at the offshore feeder level, who are wholly independent or contain a majority of independent directors, will be used as a selling point. The offering memorandum will say that the feeders will invest all or substantially all of their assets in the master. However, at the offshore level, once assets are invested into the master fund, independent governance may be lost at asset level in the event an offshore partnership vehicle is used. Realistically what can the directors of the offshore feeder do? The memorandum says that the directors have appointed the manager to carry out the primary investment objective of the fund, which is to invest in the master fund. So the manager directs investment in the master fund. What control does the board of the feeder then have over the activities of the general partner of the master fund or the investment manager providing services to the master fund? Legally? None.
In an effort to address this mismatch, institutional investors and director service providers alike are now insisting that the same independent governance model runs throughout the entire fund structure.
As noted above, if the master fund is also a Cayman Islands company that is easy to achieve. However, where the master fund is a limited partnership some legal gymnastics are required.
Structures that have begun to be used at the master fund level include the following:
- the sole general partner of the master fund is a Cayman Islands company whose board mirrors the board of directors of the offshore feeder;
- a secondary ‘governance’ general partner of that fund is incorporated as a Cayman Islands company. This company is a second general partner, that sits alongside the manager’s general partner vehicle and whose responsibilities are clearly delineated in the master fund limited partnership agreement with a focus on governance;
- the inclusion of special limited partners of the master fund who are party to the limited partnership agreement, have the benefit of limited liability but also have a role on an advisory board which focuses on governance; and
- a simple advisory board with veto powers.
In addition to adding independent governance at asset level, we have seen secondary ‘governance’ general partners provide the same services at the onshore feeder level.
This way governance practices that are instituted at the offshore feeder level can legally and enforceably be baked into the fund structure in such a way as to give real teeth to the independent directors.
These models are in their infancy and we expect them to evolve and change with time to meet the demands of all involved. However, the fundamental drivers are here to stay.
Conclusion
The governance landscape for alternative investment funds has clearly changed; whether or not this will be for the better remains to be seen. Certainly, lessons learned in recent times are being used to effect change in the way in which funds are managed and monitored. What is now the norm, was the exception several years ago with increased independent oversight and monitoring required by investors at all levels of a fund’s management. Pressure from large institutional investors and service providers has lead to a type of ‘comply or explain’ culture within the alternative investment fund world with those fund promoters who do not adopt a robust governance structure having to justify their setup and potentially losing out on investments. Whether or not increased worldwide regulatory burdens will have an impact on the business in the Cayman Islands waits to be seen, with some market participants seeing it as inevitable.
Ultimately, for all involved in the alternative investment world, there has to be a balance to ensure that increased governance does not end up creating an atmosphere that leads to less than optimum returns. Governance for governance sake will never deliver returns and it may not always protect capital in the way in which some would expect it to.
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