Complying with the spirit of regulation
Corporate governance has remained a hot topic of discussion for sophisticated and institutional investors and industry professionals alike.
The landmark case of Weavering Macro Fixed Income Fund Limited (in Liquidation) vs. Stefan Peterson and Hans Ekstrom brought attention to corporate governance practices in the Cayman Islands and was seen by many as a wake-up call for the fund governance industry.
Since then, the hedge fund industry and the local regulators have concentrated their minds on standards of fund governance. This article explores the practical implications of implementing a governance framework and addresses some of the key issues that frequently arise for regulated funds and how a board might address these in light of industry guidance. This article will also touch upon a couple of areas of increased focus in fund governance and describe some practices that boards of directors are implementing.
In 2013, the Cayman Islands Monetary Authority presented its Corporate Governance Private Sector Consultation Paper to the industry’s leading legal, accounting and financial associations. The industry feedback received by CIMA showed strong support for sector-specific guidance on corporate governance for CIMA-regulated funds. Following further consultation CIMA published its Statement of Guidance on Corporate Governance for Mutual Funds (SOG-MF) in December 2013.
The purpose of the SOG-MF is to provide the governing body and operators of a regulated mutual fund with guidance on CIMA’s minimum expectations for the sound and prudent governance of a regulated mutual fund. Some of the key corporate governance principles described in the SOG-MF include oversight function, frequency of board meetings and conflicts of interest.
On the heels of the SOG-MF came the directors registration and licensing regime requiring all directors of mutual funds regulated by CIMA and companies registered as ‘excluded persons’ under the Cayman Islands Securities and Investment Business Law, collectively called covered entities, to be registered or licensed with CIMA. The term ‘excluded persons’ relates to those persons or companies that engage in securities investment business but who are exempted from the requirement to be licensed under Cayman Islands law.
To further enhance Cayman’s robust corporate governance regime, the Directors Registration and Licensing Law gives CIMA broader regulatory powers, such as the right to refuse or withdraw registration or licensing of directors, to reject the applications of those applicants they deem to be unsuitable persons, or to impose or amend conditions on the registration or license as CIMA thinks fit. CIMA is also able to gather and retain detailed information on the directors.
With the SOG-MF being in force for just over one year and the director’s registration and licensing regime coming into force less than a year ago, operators have been defining and redefining their corporate governance practices in light of developing industry attention to sound standards and practices.
During the set-up phase of a regulated fund it is helpful for boards to establish the governance framework for the year ahead. In line with the SOG-MF, the board should consider, among other factors, the size of the fund, nature of investments and complexity of the structure in determining financial and fund information flow, frequency of meetings, risk management and service provider supervision in line with the set-up phase of the regulated fund. It is very important to establish from the start that the board is receiving relevant information on a timely basis.
In addition to information flow, it is helpful to document in one place standards of care, exclusions of liability and liability caps within service agreements being negotiated and entered into by the regulated fund. A register of agreements is a useful way to compare and monitor material contracts entered into by the regulated fund which would include the applicable standards of care and exclusions of liability.
The governance framework established by the board during the set-up phase should be reviewed frequently by the board to ensure that the framework evolves with the life of the fund allowing the board to manage risks and perform its supervisory function. Risk management issues including the management of conflicts of interest arise regularly in the ongoing phase of a regulated fund.
Side letters – Side letters continue to be popular with hedge fund managers as a tool for attracting seed or large investors. While the charm of side letters remains, there are risks to funds associated with them not to mention the administrative burden required to track and monitor them.
Common terms often include greater rights to information, reduced or waived management or performance fees or greater or enhanced liquidity terms, immediate notification of key events and most favoured nation clauses. Side letters are commonly reviewed by fund counsel prior to their entry by the board of directors and carefully monitored for compliance. To track side letter terms many funds will create a register of side letters which is routinely monitored and discussed at board meetings of the fund.
The register allows the board to monitor and manage the funds compliance with special side letter terms especially the most favored nation clauses.
Cross trades – Cross trades raise immediate red flags in the context of fund governance and should be carefully managed. Cross trading is often performed by fund managers to rebalance portfolios under management by the fund manager for any number of reasons.
The challenge for the board of directors of a regulated fund in discharging its fiduciary duties when involved in a cross-trade is that there is not always a clear benefit to be derived for the regulated fund but the benefit may be more to the wider group of funds being managed by the fund manager.
Securities rules generally mandate cross trades with strict guidelines. However, not all fund managers are subject to regulation, so it will be incumbent on the board of directors to establish internal guidelines to effectively supervise the process. It is recommended that the potential for cross trades be fully disclosed in the offering documents of the fund, that independent pricing be obtained, that management fees on the cross trade are not earned by the manager and that, in some cases, prior investor consent be obtained.
Conflicts of interest – Side letters and cross-trades have been identified as some of the key areas where conflicts of interest frequently arise. Once such conflicts are identified, a useful way to monitor them is to create a register of conflicts of interests describing the nature of the conflict and how the conflict is being managed and monitored by the fund. By maintaining an up-to-date register the board can regularly review and manage potential areas of risk and comply with the SOG-MF in documenting, monitoring, managing and disclosing such conflicts. The register is often prepared and maintained by fund counsel or by the fund manager and reviewed by the board of directors regularly.
Increased focus areas
To maintain sound fund governance practices many boards of directors are routinely performing a governance gap analysis to evaluate performance with a view to implementing or enhancing new or existing governance practices and procedures. Some areas boards increasingly focus on include in-person meetings and anti-money laundering (AML) compliance.
In-person board meetings – While the SOG-MF provides that fund boards should meet at least twice a year in person or via telephone conference call, many regulated funds are holding quarterly board meetings with at least one of those meetings being held in person.
A positive trend is that frequently administrators and auditors are also attending these meetings in addition to the directors and the fund manager. Many fund managers and institutional investors view the board as an integral part of a fund’s operations and regular meetings, including in person meetings, can indicate that a board is engaged.
AML testing – Increasingly, as part of its supervision of service providers, boards of directors are adding the area of AML testing to their list of compliance and management monitoring. During the now common annual site-visit by the fund manager with the administrator, boards of directors are requesting that the fund manager ask for an on-site spot check of the AML information held by the fund administrator as well as a report to the board of directors. This is a key way to demonstrate oversight in a relatively cost-effective manner.
Fund governance is not static and should not be carried out with a check-the-box or rubber- stamp approach. Given the increased attention and focus from investors and regulators on fund governance, failing to meet the expectations set by CIMA is likely to have negative repercussions for the directors and the fund.
Independent professional directors, often with a multi-disciplinary skill set, play an integral role in setting the standards expected by the regulator and demanded by sophisticated and institutional investors. Enhanced reporting, regular meetings, the use of tailored registers to track material information along with new practices will continue to be utilized by fund boards in compliance with the spirit of regulation which continues to evolve.