Historically, director services for Cayman funds changed very little but this has evolved during the past few years. Legislative changes introduced director registration or licensing requirements and new regulations.
In addition, law firms started to spin off their administration divisions and private equity and other buyers entered the market.
This transformation in the fiduciary services space and specifically in director services is only going to accelerate. There is a greater awareness and respect for risk, which has been highlighted during the turmoil of the financial services industry and high-profile failures of the past decade.
Future changes designed to increase transparency and to limit the number of funds serviced by any one person will initially fragment the industry as business from “high-volume” organizations disperses among a larger number of directors and firms servicing the industry. In addition, the services offered and the people involved will diversify, as the focus will be on risk mitigation through application of more specialist skill sets to the industry.
This will be followed by a period of consolidation through mergers and acquisitions resulting in a more commoditized efficient basic product along with a suite of value-added services for the funds.
Here is why …
Local and international regulations are impacting all parts of the financial industry, and funds are no exception. In Cayman, the Directors Registration and Licensing Law 2014 is now in force.
The law requires Cayman Islands-based and non-resident directors of entities regulated under the Mutual Funds Law and certain “excluded persons” under the Securities Investment Business Law to be either registered or licensed with the Cayman Islands Monetary Authority.
Individuals appointed as directors for fewer than 20 covered entities had to be registered within three months of June 4, 2014. Professional directors who are appointed as directors for 20 or more entities, as well as corporate directors, have to be licensed within six months of June 4.
The registration process has to be carried out through CIMA’s web portal. Non-professional directors have to provide their name, date and place of birth, nationality, principal and postal address, email address and telephone number, any criminal record involving fraud or dishonesty, and whether they are subject to an adverse finding, financial penalty, sanction, disciplinary action or proceeding by a regulator or professional body.
Professional directors have to file in addition a completed personal questionnaire, which is available on CIMA’s website, three reference letters, including at least one from a bank and a recent police clearance certificate.
However, the database of registered and licensed directors will not be available to the public. A search of the database will reveal only the name of the director, registration or license number and registration or licensing date.
Professional directors have to pay an application fee of US$610 and an annual fee of US$3,049.
The paperwork and fee requirements are a minimal burden, providing a low barrier to entry to operate in the industry and are just a first step.
In many other countries, it is also considered that directors must operate locally. For example, the Irish Funds Industry Association in Ireland recommends that the director of a fund has no more than a maximum of eight non-fund directorships, that they can be reasonably available to meet the central bank at short notice, the majority should be Irish residents, that the independent director is not an employee, partner, shareholder or firm providing services to the fund (e.g. custodian, administrator, auditor, legal advisor etc.) nor receiving other professional fees.
For Cayman funds, neither the directors personally nor their businesses face restrictions on the geographic location from which they operate. Given the targets of government to increase local business and employment, perhaps this is something that will change in the future.
Although the Cayman Islands Director Licensing Law does not cap the number of funds for any one director and did not introduce a public database of fund relationships for individual directors, clients need this information to be able to make an informed decision on who they want associated with their funds.
The question is how can an individual director allocate sufficient time to a multitude of funds to do an adequate job and perform the services paid for?
Clients ultimately want quality over quantity, even if they are looking for better value solutions.
Globally, there is now a greater awareness of the inherent business risks in the director services space, as losses and reputational risk from enormous fines and criminal convictions loom large.
Senior executives and decision-makers at the services firms are concerned over the potential risks and often unknown dangers.
It is difficult to quantify these risks but they are reflected in insurance premiums, as premiums that cover liability for services are typically in the low thousands per million of coverage and extremely high when compared to the consulting industry where they are in low hundreds per million.
It is also worth noting that while these policies only provide partial coverage, directors operate under “unlimited” liability.
Therefore, as the climate and awareness changes, it can be expected that new services will be delivered to help manage and mitigate the risks in the business processes.
Services that are being considered and developed now and will become standard in the future include risk mitigation, derivatives and complex strategies, in addition to other services such as utilities and outsourced roles.
One of the primary objectives of the fund is to mitigate inherent risks of operating in the fund management space. Historically, many of the risks were overlooked as they are hard to identify and even harder to quantify.
Market and credit risk commonly first come to mind. They are managed by the traders of the fund but there are many other major risk categories that need to be managed, as listed by Basel under operational risks which touch on people, process and technology, as well as reputational, regulatory risk and legal risk.
Services that aim to mitigate and reduce these risks will have a highly attractive cost benefit for the fund as the risks, despite having a low probability, are potentially so large they can have catastrophic effects.
Risk-focused solutions can enter the market offering a higher level of standards and another safety net and risk mitigation for an additional layer of protection.
The costs are very competitive and low compared to other more intensive alternatives currently available through business advisory and consulting engagements or maintaining the expertise directly in-house.
Moving forward, such risks will be quantified and valued, creating the opportunity for risk mitigation techniques to be appropriately paid for through the provision of risk management services that make up part of the suite of outsourced solutions offered to the fund industry.
Derivatives and complex strategies
There is a lack of understanding of derivatives and many preconceptions. Too often, high-profile headlines appear in the press of enormous losses and bankruptcies as a result of fraudulent activity related to derivatives.
A derivative product, in fact, is designed for risk transfer from one organization to another. Rather than regard the use of derivatives with apprehension, they simply need to be managed correctly, especially because the amounts involved are so large.
For example, an arbitrage strategy of a hedge fund to take out inefficiencies in a market entails risks that, when not executed correctly or mismanaged, could result in unexpected exposures and, under the wrong market conditions, big losses. This is why the correct oversight is needed and, with the right resources and services, the majority of these risks can be mitigated.
The utilization of derivatives is an important element of managing risk and generating alpha in any fund but the risks they introduce when not understood nor managed properly are enormous. The director services have the potential to provide an important oversight tool to manage, mitigate and control the associated risks. Therefore, appointing the right independent directors with the appropriate experience and background is vital.
For Cayman funds, two independent directors are required, though this does not limit the number who can be utilized. For a plain vanilla fund, there would be no need or requirement but for those who have derivatives in their mandate, it is in everyone’s interest (fund, director, administrator, legal, accounting and support services) that an additional role for a third independent director with the background and understanding is utilized to mitigate risk for the benefit of everyone involved with the fund. This is essential to get the correct blend of expertise and knowledge involved with any fund.
Moving forward, a third director will become the standard for complex funds, whether legally required or not. As clients develop a greater awareness of the risks, they will demand and expect this from their providers. The investors require this as a golden seal when looking at where to allocate their capital.
This is just a selection of additional services that can be provided so that funds can focus on investment management and on generating returns, rather than administrative functions, which provide no potential profitability to their business model.
These services will be especially commanded by those more sophisticated funds incorporating derivatives and complex strategies that, potentially, the investors, trustees and other interested parties do not understand. This expertise and additional services will become the standard and will be demanded by investors and management companies.
Offering these services through existing distribution channels makes the most sense, as does offering new value-added services in a package and delivery mechanism that clients understand. This makes it quicker to market and lowers barriers to entry, which exist in fiduciary services and, more specifically, the directors’ services space. In dialogue with the funds and investors, end-user clients are comfortable with this approach and they are ready and willing to pay for additional independent directors with these skill sets to de-risk their funds.
This change in services opens up the benefits of services historically only delivered as part of sizable engagements cost and length that most buyside firms could not afford to spend. However, “bite size,” “consulting light” oversight at very attractive costs whilst delivering significant risk mitigation is an extremely appealing cost-benefit return.
As seen in other segments and markets, for example, fund administration, eventually the market will mature and basic administration tasks will become commoditized and automated or processed in an efficient low cost manner. In turn, value-added tasks become the services that command a premium and generate the profit for the firms servicing the industry. Consolidation will take place, as the industry is very fragmented and can benefit from scale. This may be in the form of specialist independent organizations that just service this part of the industry and thus retain the independence and do not have the conflicts of interest. Otherwise, larger groups with complementary products and services could service the business, offering integration and cross-business incentives to having fewer of external relationships for funds.
Overall, these changes will improve the industry and lower the risks for all parts of the process and for the companies involved. That said, there will be a period of adjustment and first movers will have a big advantage as business migrates from other services firms that are slow to change.