Be careful what you wish for…

Read our article in the Cayman Financial Review Magazine, eversion 

The recent decision of the Financial Services Division of the Grand Court of the Cayman Islands in the matter of the Weavering Macro Fixed Income Fund Limited was met with a wall of noise from the industry in the Cayman Islands.

Although that of itself was no surprise, the particular tone of that noise was surprising to me at least.  

In the rush to point out the differences between the services provided by the two “semi-independent” directors in that case, and the services that would be provided by professional independent directors based here in the Cayman Islands, there is a very real risk of misunderstanding the full implications of the decision handed down by Justice Jones including, in particular, the tests laid down by him for the conduct of directors throughout the life cycle of a fund.

The judgment deals not only with the conduct of the directors at the later stages of the fund’s life when it started to emerge that something was amiss, but also lays down the tests that should be applied, according to this judgment, in assessing the conduct of directors in the establishment and operational phases of a funds life.

While many commentators have been quick to applaud the general requirement within the judgment for strong corporate governance, and further still have taken the opportunity to use the judgment almost as a marketing tool, quick to claim how they happily meet all such tests, the obligations as spelled out in the judgment would seem to me at least, to suggest a level of supervision not commonly seen in the industry.

The judgment suggests that placing reliance on the work done by highly qualified, and in many cases highly paid, professionals in relation to the preparation of a fund for launch, including the drafting and assembly of all of the relevant fund documents, is well below the standard required.

Further it seems to require independent director’s to undertake a level of review and work that requires a second guessing of the conduct and work of the lawyers, accountants and other professionals, a second guessing the full scope of which many professional directors may be uncomfortable undertaking.

The judgment notes, quite correctly, that advisors to a fund are usually appointed by the promoter or investment manager in advance of, or perhaps simultaneously with, the directors. However, it seems to be too black and white to suggest that as a result therefore, they should be taken only as the advisors of the manager and cannot be relied upon as advisors of the fund. Are not the investment manager’s and the fund’s interests aligned, at least at the commencement of the process?

How can it be said that advisors preparing documentation for the launch of a fund are not doing so in such a way that makes the fund compliant with the relevant laws and regulations? Don’t they provide the investment manager as well as the fund directors the benefit of their knowledge and expertise with regard to the laws, regulations and industry practice?

If not, must the directors effectively perform the work of lawyers, auditors etc again, and sign off on the documents in their own right? Perhaps I’m reading too much into it but, with respect, some are reading too little.

Take for instance the further suggestion that a verification exercise should be undertaken on the fund documents. Taken literally, this seems to allow the directors to place no reliance on the drafting and review undertaken by the lawyers, the review undertaken by the administrator, custodian, investment manager and other service providers, or anyone else involved in the preparation of the documents.

This requirement also seems to suggest there exists a degree of conflict between the advisors of the investment manager and the fund itself which seems incorrect at a point where the fund is being established.

Surely at this time in a fund’s life, as mentioned above, all of the interests are aligned? Although they may diverge in the future, and conflicts may arise which must be managed, it doesn’t appear correct that they are so diverged at the outset.

It is interesting to note in this regard that I have never been asked by a director to participate in, assist with, organise or facilitate a verification exercise of any sort in respect of an offering document for a Cayman Islands hedge fund.

In fact, although the fees involved in such an exercise are enough to make many hedge funds lawyers drool, the very nature of such costs would, I imagine, result in very few such exercises ever being undertaken. When applauding the requirements laid down by the judgment, what verification did those independent Cayman directors have in mind that they had performed in the past?

Remember, this judgment doesn’t just point towards the future, but purports to define the standards of behaviour that the Court expects directors to have undertaken in the past.

Perhaps even more worrying though than the apparent inability of directors to place any significant reliance on those highly paid professionals responsible for the launch phase of the fund, is the judgments suggestion that other service providers to the fund, such as administrators and auditors, have a very limited responsibility to the fund, its investors and indeed the directors, when it comes to reporting unusual activity, most particularly in the case of the hedge fund where investment compliance is not a task delegated to an administrator.

In respect of Cayman Islands hedge funds, investment compliance is not a function which the law or regulation requires is undertaken by an independent administrator, as such it is not something Cayman hedge fund administrators typically do, nor are they paid for it.

Whilst it is certainly understandable therefore that they should be allowed to rely on their contracts, which do not require them to undertake these type of checks, it seems unusual (to say the least) that they have no obligation to point out unusual, and at times down-right extraordinary, behaviour, even when perhaps it has inadvertently come to their attention.

This suggests that administrators and auditors can look at accounting and investment management activities that strike them as odd, but be under no obligation to pick up the telephone to a director, even if they feel the director has missed something?

Surely investors are entitled to take some comfort in the pedigree of the service providers appointed, and have a legitimate expectation that they serve as a further check and balance?

Although it may be valid to claim that the fact pattern in this case doesn’t follow standard industry practice (although this is clearly in dispute, and likely to be the subject of an appeal) the tests as set out by the learned judge do not, in my view, represent industry practice either, and further, if most Cayman Islands independent directors are honest, nor do such tests represent their practice.

Whilst I’m not suggesting that industry practice and the law are one in the same (indeed the courts have never shied away from pointing out that just because a particular activity has been the practice of the funds industry doesn’t mean that it is a correct reflection of the legal position) surely, in the relation to deciding what is an objective test to be followed, regard must be had to the industry within which these individuals operate, the degree on which they rely on the service providers to which they delegate various functions, and the level of limited oversight which they normally apply. 

Whilst directors would never try to argue that they are not ultimately responsible for the activities of the funds on which they serve, surely the careful selection of service providers and the delegation to them of various functions fulfil the very large part of their duties?

Finally, a word of caution to those quick to seize upon the judgment as the vindication of the notion of professional independent directors and their practices. Read it carefully, and be careful what you wish for………

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Ian Dillon
Ian is a partner in William Fry’s Asset Management & Investment Funds Department specialising in Alternative Investments with a focus on Hedge Fund formation, Alternative Investment Management regulation and corporate governance as well as providing advices on on-going matters affecting the alternative investment management industry in Ireland.  Ian is a recommended lawyer in Legal 500, Cayman Islands and Chambers Global 2013 guide notes : Ian Dillon has established a strong reputation in the investment funds arena and focuses primarily on hedge fund-related work. Clients note that he is "always reachable, pragmatic, very helpful and is there to hold your hand through the process."
Ian Dillon
William Fry
Fitzwilton House
Wilton Place
Dublin 2, Ireland

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