Alternative Investment Management Association Representing the global hedge fund industry
The period since late 2008 has been a golden age - quantitatively rather than qualitatively - of financial services regulation. The benefits to investors of the regulatory outpourings are not always easy to discern, but the beneficiaries have most obviously been professional service providers (whether working for governments or in the private sector) engaged in creating, interpreting and complying with sweeping and often clumsy efforts to impose homogeneous solutions to heterogeneous issues. Accordingly, it is with some trepidation and amid much misinformation that stakeholders in the Cayman alternative investment funds industry have waited for the output from the Cayman Islands Monetary Authority's (CIMA) consultation on corporate governance of regulated mutual funds.
This article seeks to explain and explore why the corporate governance of Cayman investment funds is receiving "the regulatory treatment", what such treatment will look like and its likely impact on the management and costs of alternative investment funds.
Directors in the spotlight
The duties and liabilities of directors of Cayman companies arise under statute and at common law. While the obligations and penalties for non compliance arise under specific statutes (such as the Companies Law and the Mutual Funds Law) and will differ according to the activities engaged in by a fund and where it transacts business (most funds will engage legal counsel to advise on applicable laws of numerous states and countries), the common law duties of a director to his or her company are well known. Under Cayman common (i.e., non-statutory) law a director owes duties of skill, care and diligence and fiduciary duties to the company. There are core duties which are substantially similar regardless of the domicile of the fund; for example, the duties to act with loyalty, honesty, competence and in good faith arise under Luxembourg law.
The collapse of investment funds as a result of the liquidity crisis of 2008 and a number of high profile frauds has prompted the development of common law as courts in the major fund domiciles consider the behaviour of directors in response to claims from liquidators and investors. In August 2011, the case of Weavering Macro Fixed Income Fund Limited (in Liquidation) provided a helpful exposition by the Grand Court of the Cayman Islands of actions that would evidence that directors were meeting their duties of skill, care and diligence to the fund. The directors in Weavering were non-executive directors and it was accepted by the court that they had a supervisory role rather than an executive role to fulfil.
The court set out actions that directors should take at different stages of a fund's life in order to fulfil their duties, the stages being: (1) establishment, (2) ordinary course of business and (3) during a crisis. The guidance provided by the court was both general - that directors must be proactive and provide a continuing (as opposed to a purely reactive periodical) oversight - and specific, such as requesting and reviewing and questioning reports from the fund's service providers.
The Weavering judgment attracted much publicity and prompted action by the general counsel of fund groups, directors and investors to critically evaluate the corporate governance procedures of their funds in light of the court's guidance as to appropriate practical steps. A few months later, in September 2011, the International Organisation of Securities Commissions (IOSCO) updated its Objectives and Principles of Securities Regulation paper which had last been revised in 2002. The IOSCO revisions recommended an increased focus by regulators on corporate governance by requiring the regulatory system to set governance standards for collective investment schemes. The Financial Times then added to the pressure on CIMA by publishing an article in November 2011, which introduced the term "jumbo directors". The Financial Times had analysed the ADV forms filed with the Securities and Exchange Commission (SEC) by U.S. managers of Cayman funds and raised concerns as to the capacity of some professional directors to adequately fulfill their responsibilities as directors of funds given the large number of appointments that they held.
After much discussion and informal consultation within Cayman, CIMA initiated a survey on corporate governance standards with stakeholders which was conducted in January and February 2013. The key issues to emerge from the responses to the survey were: (1) the experience, knowledge and independence of directors is the most important factor in corporate governance, (2) concerns as to how much time directors have available to apply themselves to each fund, (3) completeness of responses from directors to due diligence enquiries from investors, (4) no consensus emerged on the question of whether to impose a limit on the number of fund directorships an individual should hold and (5) transparency on the number of directorships held would be best managed by a database operated by CIMA.
The new regulatory environment
There will be three principal elements to the regulation of fund corporate governance: a statement of guidance with a "comply or explain" approach taken by CIMA supported by enforcement powers under the Mutual Funds Law; a new dual registration and licensing regime for directors of Cayman funds; and the creation of a CIMA managed database to assist due diligence on fund functionaries by investors. The proposals are expected to be published shortly and it should be noted that they may be amended as a result of the ensuing public consultation, which will be a period of at least 21 days. The statement of guidance is likely to be issued before the end of 2013, but the legislation required for the regulation of directors is unlikely to be in place until the first quarter of 2014.
Statement of Guidance for Regulated Mutual Funds
CIMA has taken a sensible and balanced approach in crafting a Statement of Guidance for Corporate Governance of Regulated Mutual Funds (SOG-MF). By adopting this approach, funds and their investors will be aware of CIMA's governance expectations, but new duties and standards are not introduced by statute or regulations. Alternative investment funds are international in nature and their directors are likely to be aware of codes of conduct promulgated by regulators or industry associations, such as the ALFI Code of Conduct for Luxembourg Funds, the Irish Stock Exchange Listing Code and AIMA's Guide to Best Practice. However, unlike their counterparts in Ireland and Luxembourg, CIMA will continue to allow funds to determine the domicile of their functionaries so there are no requirements for Cayman resident directors, which is sensible given the number of funds affected (over 10,000 as at the end of Q3 2013) and the limited, but growing, size of the Cayman resident director pool.
The Weavering case advanced common law on the performance by directors of their duties and the SOG-MF reflects in a shorter form the general guidance provided by the court in its judgment. However, the SOG-MF covers more than just directors as it applies to "operators" of Cayman mutual funds, which are the directors in a corporate structure, the trustee in a unit trust and the general partner in a limited partnership. All registerable funds (including master funds which are registerable under s4(3) of the Mutual Funds Law (MF Law) will be subject to the statement of guidance. The key points are as follows:
Registration, licensing and enforcement
CIMA has broad powers under the MF Law and anyone who has read a Cayman fund offering memorandum will be familiar with the summary of those enforcement powers which arise under s30(3). Section 30(1)(d) stipulates that CIMA may take any and all of the supervisory and enforcement actions stipulated in s30(3) - such as requiring the substitution of any promoter or operator of the fund - if the direction and management of a regulated mutual fund has not been conducted in a fit and proper manner. The SOG-MF will provide guidance that will assist CIMA in determining if management by the operators of the fund has been conducted in a fit and proper manner. Furthermore, the addition of a new sub-clause (f) at section 30(1) will provide a trigger for CIMA to exercise its powers under s30(3) if it is satisfied that a regulated mutual fund is not in compliance with the SOG-MF.
There are widely divergent views on the licensing of the provision of director services. There has been much debate of questions such as: should rules prescribe that a fund must have a Cayman resident director? and should licensing cover all directors of Cayman funds regardless of domicile? Most Cayman resident directors provide their services via a licensed company, and some legislative housekeeping is proposed so that such companies are licensed under a single statute rather than at present where they may fall under the Companies Management Law or the Mutual Funds Law. However, the proposals will create a new regulatory nexus between the individual directors and CIMA, as directors will need to file confidential information (in the form of electronic responses to a questionnaire) which will determine their regulatory status. Directors who sit on the boards of up to a certain number of funds (perhaps 25 - the number has not yet been disclosed) will only be subject to registration (Registered Directors) and the payment of a registration fee. Those directors who serve on a number of funds above the threshold number (perhaps 26+) will be licensed as approved persons by CIMA (Licensed Directors) and so will be required to provide additional information for CIMA to evaluate them. All information filed with CIMA, such as responses to questions relating to whether they have been or are the subject of a regulatory enquiry in another jurisdiction, will not be publicly available and will remain confidential information provided to CIMA.
These measures will be apply to Cayman and non Cayman resident directors alike. The fees payable by Registered Directors are expected to be significantly less than the fees paid by Licensed Directors, so the typical fund management company which provides one of its principals to sit on the boards of the funds that it advises will not be impacted in the same manner as a professional Cayman funds director. Those who sit on multiple boards (CIMA's data suggests that over 90% of Cayman resident directors hold less than 50 fund directorships) might see the silver lining on this regulatory cloud and find that being a Licensed Director is a positive sales proposition as they will be subject to similar regulatory scrutiny as the funds which they serve. Sensibly, no prescription has been made as to the nature of the business models employed by those providing director services and corporate directors can continue, although the entity through which the directorships are provided will be subject to the full CIMA licensing regime.
In contrast to other more retail dominated fund domiciles, such as Ireland and Luxembourg, there are no proposals to stipulate the composition of fund boards. The Irish Stock Exchange Listing Code requires that at least two of the fund directors be independent which is defined as "not having an executive function with the investment manager and its affiliates or a role with another service provider which directly involves the relevant fund". In Luxembourg, the financial services regulator has encouraged strong representation on fund boards from the relevant fund's promoter (usually the investment manager or an affiliate) as the promoter is best placed and most incentivised to minimise reputational risk. Cayman continues to be agnostic on the issue of whether applying mutual fund governance models to alternative investment funds for sophisticated investors would be a benefit or not. Since 2011 there has been a significant increase in experienced professionals establishing licensed businesses to offer director services to Cayman funds and a growing trend towards mixed boards comprised of an individual from the investment manager and two non-executive directors (unrelated financially or otherwise to each other or to the investment manager). The new regulations will, I think, encourage that trend.
A new digital database with core information on each registered fund will be established by CIMA during 2014. It is expected that further consultation will take place to determine who will have access to the database (the general public as per the SEC's ADV filings or a more limited, fee paying access) and the extent of information that will be searchable. The database is intended to assist investors with due diligence and to address one of the concerns identified in CIMA's corporate governance survey.
Will anyone notice? Will the regulations change practice?
The SOG-MF should not take any fund by surprise. It is a statement of practice that has been (and if not, certainly should have been followed) at the least since the Weavering judgment in August 2011. Many funds and their service providers have been operating in accordance with the SOG-MF for many years. Manager and investor preference may have been to keep costs down, but it is likely that the cost of a qualified, experienced board with the time to devote to their role will go up as a result on the constraint on numbers of appointments is imposed by the pincer of data transparency and the trend towards experienced and credible directors that are independent of each other and able to manage conflicts that arise between a fund and its service providers. The institutionalisation of alternative investment funds continues and brings with it a culture of control and independence. Self-administration is now consigned to history and old manager-centric corporate governance models are likely to follow suit. Unfortunately, improvements come with at a cost. The new Cayman regulations are expected to raise approximately $6 million per annum for CIMA from the licensing fees payable by those serving as directors and other operators to the funds. The benefits are not so easy to quantify in financial terms, but CIMA's focus on quality in ensuring high and enforceable standards of corporate governance should benefit investors and managers alike.
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