In an ever-changing regulatory environment that requires greater oversight and transparency from hedge funds, investment managers must now be vigilant in their governance practices to ensure compliance and optimum service to the investors they serve. In this article, I want to discuss seven key elements for effective fund governance. These draw on DMS’ Annual Fund Governance Review 2014.

Annual Compliance Review

Investment managers registered under the Investment Advisers Act of 1940 (the “Act”) are required to conduct an annual compliance review pursuant to Rule 206(4)-7 of the Act. This review includes evaluating the capacity of service providers to serve investment funds that are managed by Registered Investment Advisers. It’s imperative to recognize that the service providers of a fund include its directors and they should not be omitted from this annual review. Annual compliance reviews should ensure that the fund’s directors have adopted internal controls and procedures that are consistent with applicable rules and regulations, including risk management, independence, data security (particularly MNPI), business continuity, recordkeeping and other key business controls, that relate to the ability of the Adviser to meet its obligations under SEC rules and regulations. It is important for an Adviser to maintain proper documentation of this review as it is a focal area of the SEC National Exam Program. Under this Rule, service providers (including fund directors) to investment funds managed by registered investment advisers are required to have “implemented effective compliance policies and procedures administered by competent personnel and should provide the compliance officer with periodic reports”.

It should be noted that commodity pool operations must conduct a compliance review similar to the requirement of investment managers under the Act.

Board Review

Board performance, including any committees, should be assessed at least annually. This assessment should take into account whether the composition of the board, the capacity of its members, plus the frequency (and location) of its meetings, transparency reporting and other governance output, meet stakeholders’ expectations. The Cayman Islands Monetary Authority (CIMA) recently issued a new Statement of Guidance (SOG) that requires, among other standards, all CIMA regulated funds to hold board meetings at least twice per year. Compliance with the new SOG need not be onerous or expensive with proper planning.

Funds should also review the tax status of the board members annually. They should ensure that any directors or officers of the fund that are U.S. persons, have provided the fund with proof that the director or officer has made any required personal tax filings to the IRS. U.S. citizens and U.S. residents who are officers, directors, or shareholders in certain foreign corporations (including offshore investment funds) are responsible for filing Form 5471 Information Return of U.S. Persons With Respect to Certain Foreign Corporations. The form and attached schedules are used to satisfy the reporting requirements of transactions between foreign corporations and U.S. persons under sections 6038 and 6046 of the Internal Revenue Code. Substantial penalties exist for U.S. citizens and U.S. residents who are liable for filing Form 5471 and who failed to do so.

The location of the board meetings is also important. In recent years, a series of U.S. court decisions have found that the center of main interests (COMI) of various Cayman Islands funds was not in the Cayman Islands. An important consideration of these courts in determining the COMI included the finding that “none of the directors resided in the Cayman Islands and there was no evidence of any board meeting taking place there”. If a Cayman Islands fund is assumed by an official authority to not conduct a trade or business in the Cayman Islands, it may cause adverse tax and regulatory consequences for the fund. It is our view that “substantially all” of the board meetings of a Cayman Islands fund be conducted in the Cayman Islands.

It is also prudent to review the independence and any conflicts of interest of the fund’s directors. In February 2013, the SEC announced that exemptive order compliance would be a focal area of the SEC National Exam Program. SEC exemptive relief is extensive and, in many circumstances, provides significant competitive advantages to a fund while reducing its costs. However, Advisers relying on SEC exemptive relief must carefully ensure compliance with the applicable SEC rules and regulations, including the SEC independence standards. The SEC maintains strict independence standards that include, among others, requiring that the directors of a fund not be affiliated with its legal counsel.

Investor Relations Review

Investment managers should review the effectiveness of fund governance transparency reporting available to investors and their expectations for 2014. They should seek to promptly resolve any expectation gaps. Transparency is the new normal and a key focal area for investors.

Fund Document Review

Material fund documents, including marketing and performance advertising information, should be reviewed at least annually to ensure the documents are fully and fairly informing investors of current practices, considering the pace of regulatory changes in the industry, and our obligations as fiduciaries.

Rule 506 Review

SEC Rule 506 under Regulation D provides an exemption for limited offers and sales of securities, if the issuer is able to satisfy at least one condition of Rule 506 deeming the transaction a private offering. In July 2013, the SEC adopted new amendments to Rule 506 to disqualify securities offerings involving certain “felons and other bad actors”. This is important because many hedge funds file Form D and rely on this “safe harbor” exemption under Rule 506(d) to raise unlimited amounts of money. Non-compliance with the new rule may mean an inability to attract investment from accredited investors plus increased exposure to SEC enforcement actions.

Although the SEC only requires re-certification for continuous, delayed or long-lived offerings to occur on a periodic basis, we believe that it is prudent to have annual re-certification of Covered Persons.

FATCA Readiness Review

Complying with the Foreign Account Tax Compliance Act (FATCA) is a serious governance concern as the withholding penalties and other consequences are severe and potentially irreversible (withholding penalties for non-compliance are generally nonrefundable). Investors have already begun requiring funds to formally attest to their FATCA readiness in side letters.

In its simplest form, being FATCA-ready means appointing a FATCA Responsible Officer (FRO) to a fund, and obtaining its Global Intermediary Identification Number (GIIN). Once this occurs, the fund will be “registered deemed-compliant” under the Cayman Islands Intergovernmental Agreement (IGA) with the U.S. and the U.K. (more IGAs are expected). The FRO is required to be an actual director or officer of the fund and has four primary responsibilities: (1) registering a fund with the IRS and obtaining the GIIN; (2) overseeing the FATCA compliance work of the administrator; (3) answering inquiries from the various tax authorities under the IGAs; and (4) remediating any matters arising under the IGAs.

Funds should finalize their IRS registration prior to 25 April 2014 to receive their GIIN on June 2, 2014. This is the prudent approach. It is important to note that all FATCA registration is directly with the IRS and is occurring now through the end of 2014.

The IGA provides an additional six months to obtain a GIIN, but relying on this relatively short extension may prove commercially impractical as withholding agents generally will be required to begin withholding on withholdable payments made after 30 June 2014.

The growing industry consensus is that the GIIN requirements of each withholding agent will vary based on their own risk interpretations, so in the absence of ironclad written guarantees from each withholding agent, obtaining a GIIN is prudent commercial assurance against inadvertent withholding, delay, or disruption in the counterparty relationships of a fund.

Moreover, any new counterparty account opened after 1 July 2014 must immediately be FATCA compliant so this is another important consideration in managing the counterparty risk, preserving the market access, and operating flexibility of a fund. There is no benefit to waiting. The GIIN is available at no cost from the IRS.

It is important to remember that, although FATCA applies globally, it is ultimately U.S. tax law. There is still some misunderstanding and conflicting advice about FATCA and the role and responsibilities of the FRO in the Cayman Islands and other offshore jurisdictions. While this is not uncommon with new, fast-moving legislation of the scale and complexity of FATCA, for the avoidance of any doubt, it is prudent to rely only on the advice of counsel qualified in U.S. tax law.

AIFMD Review

The Alternative Investment Fund Managers Directive (AIFMD) is a requirement for any fund launched post July 22, 2013 and marketed in an EU domestic market. For funds existing prior to this date, there is an exemption to July 22, 2014 and funds must comply during this period or permanently cease all marketing in the EU. This would not require forced redemptions of current EU investors, but it will restrict the ability of the fund to accept additional subscriptions in certain European domestic markets. To permanently continue marketing in Europe there are three options.

First, register the fund on a single country-by-country basis. This allows the fund to be marketed on a private placement basis in that specific country only. There are ongoing reporting requirements depending on the country.

Second, establish a European Alternative Investment Fund (AIF). This allows the fund to be marketed on a pan-European basis (with certain country specific caveats). This requires an European AIF management company which will perform the management functions (including risk), act as promoter for the fund, and appoint the sponsor as its investment manager and distributor.

Third, join an approved AIF platform with the platform provider acting as the AIF management company. This AIF provider will then have all regulatory reporting requirements in addition to those responsibilities listed under option two.

The seven elements discussed here should be viewed in the context of the twin forces of regulation and institutionalization that are now shaping the hedge funds industry. Governance requirements are shifting to more transparent performances and fund managers will need to adapt to such standards to continue to thrive in the future.

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