Directors. The LAW REPORT. The History of Cayman Company Fund Governance. The Origins

Transcription

1 Hedge The Fund LAW REPORT hedge fund law and regulation Directors Corporate Governance Best Practices for Cayman Islands s By Tim Frawley and Peter Huber With the financial crisis of 2008 and 2009, corporate governance practices in the global alternative investment funds industry came under the microscope. While investor views on how fund directors performed during the crisis vary, what is clear a few years on is that investors, hedge fund managers and service providers have a much better understanding of the role of an independent non-executive director of an alternative investment fund and that a best practice framework has started to become a topic for active discussion in the industry. As a result, hedge fund investors particularly institutional investors are increasingly scrutinizing a fund s corporate governance structure to ensure that the directors are diligently and skillfully performing their duties in the best interest of the hedge funds on whose boards they serve. With the global hedge fund industry having its largest presence in the Cayman Islands, this article looks at some of the issues relating to corporate governance from the Cayman fund perspective. This article begins with a historical accounting of Cayman company fund governance. The article then explains the various duties owed and roles performed by fund directors. Next, the article discusses the findings and implications from the Weavering Macro Fixed Income Fund Limited (In Liquidation) (Weavering) decision handed down last year. The article then moves to a survey of some current hot-button issues related to fund governance, and concludes with a discussion of anticipated fund governance challenges facing hedge fund managers. The History of Cayman Company Fund Governance The Origins The development of modern day hedge fund structures in Cayman was driven originally by a number of factors, including the need to provide different feeder vehicles for separate groups of international and tax exempt investors for a variety of reasons, such as tax and regulatory filing requirements and to allow for different commercial terms. To use a Cayman company as a feeder fund necessarily means directors need to be appointed since it is integral to the function of a company. Management power of a company is vested in its board of directors. Therefore, without a board, there is no one to exercise those powers. There is no requirement of Cayman Islands law that the directors be resident in Cayman, and that is still the case today. However, for a number of reasons, it was very often regarded as helpful to have board and shareholder meetings held outside the jurisdiction where the hedge fund manager was located. For example, the treatment of a fund under the rules in some jurisdictions concerning the place a fund is deemed to have a permanent establishment or place of business for tax purposes could be affected if the fund s directors were resident or regularly met in those onshore jurisdictions. A practice evolved of having directors resident in jurisdictions such as Cayman. In the early days, directors came from two principal sources persons such as retired accountants, bankers or lawyers

2 who operated independently and fund administrators who provided the services of two or three of their senior staff. A board might comprise a mix of these individuals with perhaps the hedge fund manager also providing one person to act as a director. As the alternative investment fund industry grew, the use of corporate feeders continued as the legal structure of a company provided hedge fund managers with a tax efficient manner in which they could receive their incentive fees. Hedge fund managers would typically elect to defer receipt of earned incentive fees, and as a result the fee was not subject to current taxation. The ability to defer tax was coupled with a requirement for the hedge fund manager not to have control of the fund either through voting shares or through the board, which, in turn, generated a continuing interest in the use of independent directors. However, relatively recent changes in U.S. tax law generally require immediate income recognition in these structures going forward thereby removing the ability to defer taxes on the fee income. See New Tax Law Restricts Fee Deferral Arrangements, The Law Report, Vol. 1, No. 22 (Oct. 10, 2008). In more recent years, the practice has moved away from administrators in favour of independent professional fiduciary service providers, and it has certainly become more institutionalised. This is principally due to fiduciary services not being core to administrators businesses coupled with a market expectation of greater independence in the appointed board. See The Case In Favor of Non-Executive Directors of Offshore s with Investment Expertise, Fewer Directorships and Independence from the Manager, The Law Report, Vol. 3, No. 50 (Dec. 29, 2010). The Financial Crisis Until the difficult financial times of , corporate governance did not seem to be regarded as significant to the overall structuring of a fund for investor protection purposes. Until that time, it was almost always the case that investors could redeem their shares at their will if they had issues with a hedge fund manager or a fund. However, the market paralysis and other liquidity problems of the time meant that was simply not possible. Funds imposed gates, and redemptions were suspended. These restrictions were often imposed by the directors upon advice of the hedge fund manager and legal counsel, and in the minds of investors, this highlighted the fact that a strong board could mean the difference between a long drawn out suspension and a plan to allow investors to exit in relatively short order. In turn, this brought into focus issues such as director responsibilities and their fees, exculpation/indemnity provisions and the availability of directors and officers insurance (D&O insurance). While investors had reservations about some of the governance models in place, these models did not spawn a flood of law suits. Granted, there have been some high profile matters in court, most notably Bear Stearns, but for the most part, independent boards of directors performed their duties well in the face of unprecedented circumstances. The Present Day What is clear is that the demand for independent directors has increased. A legal structure that was initially used for tax considerations has evolved to provide investors with an independent check and balance on managers in more difficult times. Those independent directors now come essentially in two varieties those who work on their own and those who work with a professional fiduciary services company.

3 The Duties and Roles of Fund Directors What Are the Main Duties Owed by Fund Directors? Directors of a Cayman company, whether independent or not, have duties to the company that they serve. These break down into fiduciary duties and duties of care, diligence and skill. The fiduciary duties may be described as being those of loyalty, honesty and good faith owed to the company. Therefore, directors must act bona fide and in the best interests of the company. They must exercise their powers for a proper purpose, must not improperly fetter their discretion and need to disclose conflicts of interest. Each director also owes a duty of care, diligence and skill to the company. This standard of care is traditionally regarded as subjective. However, it appears to be evolving to a more objective standard reflecting the skill, care and diligence that would be displayed by a reasonable director under the circumstances. Directors duties are owed to the company itself, which means they should consider the collective interest of shareholders and, if the company is of doubtful solvency, creditors. Notably, the duties are not to the hedge fund manager, even if it is the person that can control the appointment and removal of directors (see further below). Since the duties are owed to the company, any formal steps against the directors have to be taken by the company itself. That might happen through the non-defaulting directors causing the company to take action against the defaulting director. It might also happen through a shareholder derivative action in cases where the board refuses to act or if the company has been put into liquidation through the liquidator, causing the company to take action. Liquidators will certainly be encouraged by the company s creditors and shareholders to investigate the role played by the directors in the company s collapse and, if appropriate, to pursue the relevant directors personally. While not exactly the same fact pattern, this is essentially what happened in the recent Weavering case. In serious cases, directors may be prosecuted, either by the Attorney General or by the liquidator, if it appears they have been guilty of a criminal offence. Directors can be held personally liable to contribute to the corporate coffers if they are knowingly party to the carrying on of business with an intention to defraud creditors of the company. The Role of Fund Directors If a corporate fund has to have fund directors, what role do they play these days, bearing in mind their duties? This question is the subject of current discussion in the industry, and the answer continues to be formulated. Through process of evolution, the role of the independent director has changed over time to become more of a high-level check and balance. Like directors, the hedge fund manager to the fund is also likely to be a fiduciary, but conflicts of interest may arise in the discharge of those duties, and having independent directors can provide an impartial check and balance. Recent market surveys show that governance structures and independent directors are an essential part of the due diligence process for institutional investors, and in the absence of satisfactory answers, investors are willing to decline the opportunity to invest. See Legal and Operational Due Diligence Best Practices for Investors, The Law Report, Vol. 5, No. 1 (Jan. 5, 2012).

4 Directors are appointed/elected to manage and direct the affairs of the company. The independent director is essentially non-executive, given that day-to-day management is delegated to professional service providers such as the hedge fund manager and the administrator. It is exceptional for these fund vehicles to have dedicated employees. The directors role is principally to provide a non-executive level of fiduciary oversight in accordance with the structure outlined and disclosed in the PPM. It is the hedge fund manager s expertise that investors want first and foremost, and that is what they pay for. The board is not expected to back-seat drive, but rather to have the role of high level supervision. Accordingly, significant day-to-day attention is not required and, arguably, nor is it sought or paid for by investors. Investors will make their investment decisions based on who will be making the investment choices. They do not expect the independent directors to be challenging or questioning investment management decisions. The directors can be expected in the ordinary course to meet perhaps quarterly (or less frequently depending upon the fund) and review fund net asset values and administrator reports, performance of the fund, the audited financials and communications to investors. On an ad hoc basis, the directors review restructuring proposals, suspensions, gates, side letters, new share classes and other matters outside the scope of the original deal with fund investors. In some cases, independent directors should also encourage critical thinking and discussion, and challenge mindsets of the hedge fund manager and other service providers. Therefore, when a proposal is presented to the board for approval, the independent directors should initiate discussion with a view to exploring whether the deal that is being presented is in the best interests of the hedge fund. Many directors, or a suitably qualified delegate of the directors, perform a physical operational due diligence site visit of the hedge fund manager s premises on a regular (typically annual or bi-annual) basis. The directors should ensure that they understand how the middle and back office functions of the hedge fund manager operate, and they should have a general understanding of how the hedge fund manager manages market and operational risk. The directors should be comfortable that there are appropriate controls in place to allow for the proper segregation of duties between trading and risk management. The fees paid to the directors should be commensurate with the role being performed. With a corporate secretary to assist in arranging meetings, preparing board materials and drafting of minutes, the directors should be able to devote their full expertise and attention to fund matters at the appropriate time. The Weavering Case Readers following the subject of fund governance will be aware of the judgment handed down in August 2011 by the Grand Court of the Cayman Islands in relation to the Weavering case. For an in-depth discussion of the Weavering case, see Cayman Grand Court Holds Independent Directors of Failed Weavering Macro Fixed Income Fund Personally Liable for Losses Due to their Willful Failure to Supervise Fund Operations, The Law Report, Vol. 4, No. 31 (Sep. 8, 2011). Weavering Macro Fixed Income Fund Limited (Fund) collapsed in the wake of the financial crisis in 2008 when it came to light that various

5 interest rate swaps apparently heavily in the money and entered into with a related entity were found to have been fraudulently created by the principal of the Fund s manager, Mr Peterson. The Fund was structured in the usual way, contractually delegating responsibilities for investment strategy and trading to a hedge fund manager and accounting functions to a professional administrator. The only unusual feature was that Mr Peterson s brother and their elderly stepfather were the sole directors of the Fund. The liquidators central allegation was that the directors had wilfully failed to discharge their duties of skill, care and diligence to the Fund which, if discharged, would have caused them to discover the fraud and save the Fund considerable losses. The directors enjoyed the usual indemnity and exculpation afforded to them in the Fund s articles of association, which applied save in circumstances where their conduct amounted to wilful default. The Grand Court adopted the familiar English authorities on directors duties and held that the test for establishing wilful default was whether each director either: (1) knowingly and intentionally breached his duties to the Fund; or (2) acted recklessly in the sense of not caring whether or not his acts or omissions were a breach of his duties. The case proceeded under the first limb of the test, as the trial judge was apparently willing to draw the inference that the relevant conduct was so egregious that it must have been intentional. It was common ground in the case that the directors, being independent non-executive directors, had a high level supervisory role to fulfil. It was the precise nature of that role in the particular circumstances of this Fund that was disputed and explored in the judgment. While no new law came out of the judgment, it has caused participants in the fund industry to pause and think further about governance structures. Current Issues in Cayman Fund Governance Independence While there are many suitable individuals who offer their services as independent directors, the provision of independent directors has become much more institutionalised with a number of independent professional fiduciary service providers having entered the market in recent years. The larger institutions have the ability to ensure no one fund or complex of funds generates fees to a level that might influence their independence. They are independent in the sense they are not owned or controlled by hedge fund managers, the persons against whom they are to serve as a check and balance. Persons who have familial relationships with the hedge fund manager are also not likely to be considered independent. Fund Establishment It was suggested in the Weavering case that independent directors should satisfy themselves that the overall structure of the fund is broadly consistent with industry standards and that the terms of the relevant service providers contracts are reasonable. Independent directors should work closely with the hedge fund manager and legal counsel to ensure that the fund is properly established. At a minimum, the directors should undertake a comprehensive review of the fund s documentation, including the memorandum and articles of association, offering document, investment management agreement, administration agreement, custodian/prime brokerage agreements and any other agreements that have been, or are proposed to be, approved and executed by the fund. Particular attention should be given to ensuring that summaries of the underlying agreements, disclosures on valuation policies and the policy on suspensions of NAV and redemptions and the imposition of gates, are all accurate.

6 Board Meetings Board meetings should be convened to discuss matters of substance and not simply to rubber stamp routine matters raised by the hedge fund manager. An agenda prepared and circulated in advance reflecting input from the manager, administrator and the directors themselves is indicative of a proper meeting. When appropriate, specific reports from the fund s manager or administrator should be requested by the directors. Insurance D&O insurance for the directors, purchased by the fund, is increasingly becoming a requirement not only for service providers but also for investors. In A Guide to Institutional Investors Views and Preferences Regarding Operational Infrastructures, published by the Alternative Investment Management Association, it is noted that there is an institutional investor expectation that adequate D&O insurance is in place for the directors. D&O insurance should allow the directors to discharge their duties notwithstanding the fund may be in financial difficulty. If there are questions of solvency, the fund may be unable to indemnify the directors, and that may compromise their ability to do their job at a time when the fund needs it the most. For a detailed discussion of D&O insurance, see D&O Insurance: Purpose, Structure, Pricing, Covered Claims and Allocation of Premiums Among Funds and Management Entities, The Law Report, Vol. 4, No. 41 (Nov. 17, 2011). Appropriate Number of Directorships Whilst it may not be appropriate to come up with a fixed maximum of directorships, independent directors should ensure that their total number of directorships does not impact upon their ability to perform the above described roles and responsibilities fully, whilst leaving a sufficient time buffer to deal with any extraordinary events or crises. In determining capacity, individual independent directors should be entitled to leverage off the resources of other persons within their employ (or employed by other organisations) provided that they exercise sufficient oversight of any delegated tasks and have an appreciation that the ultimate responsibility remains with the individual independent director. Many factors impact the number of actual directorships a professional can hold. An individual acting on his own has a very different capacity level as compared with the professional directors working in specialised service companies. Every engagement should be assessed on its own merits with directors appointed based on appropriate experience, capacity and fund relationships. See Eight Corporate Governance Steps That Managers Should Consider in Response to Concerns Expressed by Institutional Investors, The Law Report, Vol. 4, No. 35 (Oct. 6, 2011). Fit and Proper to Serve It is a statutory requirement that the directors of a Cayman regulated fund be fit and proper. The background and experience of a director is key to assessing whether a director is fit and proper to serve. Former fund accountants, bankers, hedge fund managers, lawyers and those from risk management and compliance backgrounds are individuals that typically comprise the independent component of the board of directors. These individuals understand the fund structures and investment strategies behind them. Experience or grey hair is the other key factor to being a fit and proper director. A minimum of 10 years postqualification experience in the alternative investment fund

7 field should be enough experience to be able to make the required judgments, particularly during difficult times. Directors should be free to seek outside advice on technical matters to ensure that decisions are made with a complete understanding of the issue at hand. The more experience a director has, the more likely it is that he or she will have seen an issue before, and thus, the more likely he or she will be to know when to take advice. What Does the Future Hold? When markets went into crisis mode and liquidity dried up in some asset classes, with hedge funds facing unprecedented levels of margin calls and redemption requests, board meetings were convened on very short notice, and fund directors faced some very tough decisions. On the whole, the perception is that the independent director community performed well and added significant value in terms of independent oversight of hedge fund managers decisions. Those with experience who remembered who they owed a duty to, who were willing to take proper advice and who had the right internal support framework in place, arguably had a hand in preventing certain hedge funds from collapsing. There have only been a few instances of litigation which, for the most part, tended to surround the decision of a hedge fund with illiquid assets to continue a suspension for an extended period, perhaps where the hedge fund manager has continued to charge fixed fees, as in Re Wyser-Pratte Eurovalue Fund. See Cayman Islands Grand Court Rules that Investor in Wyser-Pratte EuroValue Fund Is Entitled to Court-Imposed Liquidation of Fund, Even Though Fund Is Solvent, but Gives Fund Time to Complete Liquidation On Its Own, The Law Report, Vol. 3, No. 45 (Nov. 19, 2010). Of course, there are structural challenges to more robust corporate governance. At a very basic level, the vast majority of hedge funds are still established with split capital structures, with investors holding non-voting participating shares and the hedge fund manager (or an affiliate) holding voting nonparticipating shares. While this might at first blush seem surprising, it needs to be remembered that class rights of investors cannot in general be varied without first getting the consent of the class. However, what the structure does facilitate is the appointment and removal of directors without any input from investors. As a matter of law, the directors will always have their duties to the company and not their appointor, but in practice, one can understand that that might not work as well as it should. One way in which that risk could be re-aligned is to have the initial slate of directors re-appointed by the shareholders after a period of time or to have director resignations and re-appointments by rotation as with public companies. Onshore feeder funds are often limited partnerships or U.S. limited liability companies (a corporate entity with partnership like features). Master funds in Cayman are often limited partnerships or companies. In the case of funds that are partnerships or limited liability companies, it is frequently the case that the general partner or managing member is the hedge fund manager or an affiliate of the hedge fund manager. These structures have been historically built on the theory that an investment in the fund is a play on the hedge fund manager, and since the reasons for the genesis of offshore corporate feeders are not applicable to onshore or master funds, then absent any legal or regulatory imperative, there has been no particular reason to institute a corporate boardtype structure. However, a number of institutional investors and allocators have visited Cayman in the past year and one thing is clear almost all of them would like to see onshore/ master fund structures move in the same direction as offshore feeders to establish a corporate board-type structure. Time will tell whether this comes to pass.

8 Tim Frawley is a Partner in the Investment Funds practice of Maples and Calder and has extensive experience in the use of offshore finance vehicles, from investment funds such as hedge, credit opportunity and private equity funds, to structured debt products such as CDOs, securitizations and SIVs. Peter Huber is Global Co-Head of Maples Fiduciary Services and has extensive experience in both the onshore and offshore financial services industry. He serves as an independent director on a range of investment fund products, including multi-manager funds, hedge funds and private equity funds.