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Split boards favoured as fund governance intensifies

On 6 December 2013, after a period of consultation with industry practitioners, the Cayman Islands Monetary Authority (CIMA) – the Islands’ financial regulator – released its Statement of Guidance for Regulated Mutual Funds (‘SoG-MF’).  In essence, the SoG-MF codifies and sets guidance on the minimum corporate governance standards required by operators of regulated mutual funds (directors, general partners) and gives the operators a clear understanding of their primary duties.  

CIMA expects the oversight, direction and management of a regulated mutual fund to be conducted in a fit and proper manner in accordance with the Mutual Funds Law. The Statement of Guidance seeks to provide the governing body of a regulated mutual fund and its operators with guidance on the minimum expectations for the sound and prudent governance of the mutual fund.

“The Statement of Guidance itself is not directly enforceable by CIMA, although CIMA will look to the Statement of Guidance as a guide should CIMA need to consider whether the direction and management of a regulated mutual fund has been conducted in a “fit and proper manner” as required by the Mutual Funds Law,” says Chris Humphries, Managing Director, Stuarts Walker Hersant, a leading Cayman Islands law firm.

“It is imperative that Cayman not only has sufficient regulation to be considered relatively safe and stable for investors but also to provide practical, user-friendly advice on the practical operation of the laws to such funds in order to maintain Cayman’s position as the premier jurisdiction to incorporate a fund.

“Accordingly, the issue of the Statement of Guidance will further enhance Cayman’s reputation for seeking to balance effective regulation with pragmatism.”  

Directors registration and licensing law

Currently, there is a continued trend towards enhancing the overall corporate governance of Cayman hedge funds. The look and feel of boards of directors is more focused, more independent, whilst the introduction on 4 June 2014 of the Directors Registration and Licensing Law by CIMA means that CIMA now has a clearer picture of Cayman fund directors. Each relevant entity is defined in the DRL Law as a “Covered Entity”.  

“The rationale for the Law is founded in the Cayman Government’s initiative to continually enhance standards of corporate governance and increase transparency in the sector,” says Humphries.  

“The register noted in Section 23 of the Directors Registration and Licensing Law, 2014 is basically a housekeeping provision since all registered, professional and corporate directors are directly regulated by the Cayman Islands Monetary Authority (CIMA) under this law. The register is the means by which CIMA keeps track of such persons. We consider this to be both customary and useful,” comments Don Ebanks, Executive Director, Chief Compliance Officer, DMS Offshore Investment Services, Cayman’s leading fund governance firm serving client funds with assets in excess of USD330bn.

On or before 15 January 2015, each registered or licensed director (whether they are a natural person or corporate director) must provide CIMA with information in a prescribed form and pay their annual fee for 2015. Failure to pay the annual fee by 15 January 2015 will give rise to a penalty surcharge of one-twelfth of the annual fee for every month or part of a month that the fee remains unpaid.  There are categories of professional directors who are exempt from licensing. For example, directors and employees of an entity that holds a Companies Management license have the benefit of the Section 16(1) exemption. There is a similar Section 16(2) exemption available to many managers.

“I think the DRL is helpful. The obvious scenario that CIMA is looking to avoid is one where individuals who are unqualified, have been guilty of some past misconduct or have perhaps been subject to serious sanction by foreign regulators find their way onto the boards of new Cayman funds. Previously CIMA would have had no way to hold up the registration of funds with such individuals on the board. Now it can, as potential directors need to register with and be vetted by CIMA in advance,” comments Neal Lomax, Partner, Mourant Ozannes.

This mechanism enables CIMA to at least guard against directors who have perhaps previously had market or regulatory infractions and this gives further protection to the end investors; many of whom are themselves taking much more interest in who the directors are and what their core expertise is.

“From a good governance perspective, it gives CIMA the ability to have a better feel for the directors, especially the investment manager directors and those sitting on multiple funds. It will help them gather their own internal statistics. As for the fees, we should remember that there is a degree of administration required. CIMA is not as big as some European regulators and needs the cash to implement it properly,” says Ingrid Pierce, Global Managing Partner at Walkers (Cayman).

Could the Registry, with its improved directorship transparency, lead to a reduction in the number of directorships held by individuals? In particular professional directors for whom sitting on boards is a full-time occupation?

“CIMA has resisted until now imposing any sort of cap on the number of directorships that local independent directors have. I think that is a sensible approach to take because counting the number of directorships in a useful way and determining what constitutes too high a number is not easy. Within any particular fund structure there may be different entities, which invest in the same strategy and are all related. An independent director might argue that numbers of ‘relationships’ should be counted rather than appointments to individual boards,” says Lomax.

The suitability of “jumbo directorships” has been debated at length and attracted media headlines but as Giorgio Subiotto, Partner at Ogier (Cayman) points out, a directorship is a personal appointment.  

“There are personal liabilities attached to it if you don’t carry out your responsibilities as the law requires you to do. It’s therefore up to the individual directors to decide if they are up to the job. Directors that run “jumbo directorships” are comfortable taking on large numbers because they have the processes and procedures in place, and the infrastructure, to cover a large number of directorships while still fully carrying out their duties and responsibilities.

“I don’t think CIMA will therefore seek to limit the number of directorships. Where it could become an issue, and is perhaps what institutional investors will be looking at, is in the context of a serious financial event impacting the markets like 2008. What if the director is sitting on a large number of funds that all get suspended at the same time? That’s where these jumbo directors will start feeling the heat and where the process might come unstuck.  “That is where the tension potentially lies,” says Subiotto.

Shameer Jasani, also a Partner at Ogier, says that ultimately it comes down to a question of capacity. “What I would say in defence of the jumbo directorships is that at Ogier, we are seeing managers and investors looking for complementary boards of directors as part of the trend to truly mix boards, and create real independence. That might include an ex-lawyer and an ex-administrator, for example, but it might also include a more niche director services provider and someone who has a more leveraged model, providing the benefits of both models. We’ll see how it plays out but at the moment there seems to be room for everyone.”

Although not yet available, consideration has been given to a directorship database to enable investors to search for fund entities and obtain details on the board composition.  “That will allow the industry to self-regulate because if and when that becomes available the big institutional investors performing their due diligence will make sure they know how many funds a director holds and if they are not comfortable with that number they won’t invest in the fund,” adds Lomax.

Split boards favoured by managers

In November 2014, Walkers released their Global Hedge Funds Outlook 2015 survey. What is clear from the survey is that split boards are now being favoured by managers as opposed to purely independent boards. Combined boards (utilising both independent directors and internal directors) now make up 67 per cent of Cayman funds registered in 2014, compared with 52 per cent in 2013. Approximately 81 per cent of combined boards have a majority of independent directors according to the survey’s results.

“It has been a subtle but gradual change over the last few years to get to that point,” says Pierce. “Even before we have conversations with managers about who they might consider suitable for an appointment to the board, they will often tell us, ‘Okay, so we need to appoint independent directors don’t we?’ In the case of a Cayman fund it’s not legally required, it’s just become standard practice.”

Another key finding, which further extends the narrative arc in respect to increased corporate governance, is that managers of Cayman funds are preferring to use directors from more than one service provider: 65 per cent compared to 57 per cent in 2013.  This demonstrates that managers are not just randomly selecting independent directors, they are selecting the most suitable ones that have the right skill set and experience to add value to their strategy.  

“Managers are being much more particular about it. One of the things we are seeing is that in discussions with potential independent directors managers are really drilling down to understand what experience they have. It used to be common to have two directors from the same shop; that was pretty standard. Nobody really questioned that in the past so that is something that has clearly evolved in the last couple of years,” states Pierce.

Subiotto notes that with US managers, whereas previously the two independent directors were used on the boards of feeder funds for tax reasons, now the focus is very much on what they are doing; what independence are they bringing to the table?  

“Investors aren’t necessarily looking for directors to intervene in the executive management of the company. They would not expect directors to be reviewing PB statements on a weekly basis to see whether transactions reconcile; rather, they would expect the directors to have two to four board meetings a year to receive reports from the various service providers being used by the fund, and in the interim, investigate anything unusual that comes to their attention.  “What institutional investors are keen on is having someone on the fund’s board that they can speak to if and when a crisis occurs. They want an active line of communication at the top level of the management of the fund,” comments Subiotto.  The Exempted Limited Liability Company

From a product evolution perspective, draft regulation relating to the creation of an Exempted Limited Liability Company (“ELLC”) continues to make progress. Indeed, it is anticipated that ELLCs will, in the near future, be available as an alternative legal form of vehicle for the formation of funds in the Cayman Islands.  Currently, it is not possible to form LLCs in the Cayman Islands. The solution is to merge the relevant LLC into a newly formed Cayman Islands company, pursuant to which the rights and obligations of the LLC vest in the surviving Cayman Islands Company, and the source LLC is dissolved, in accordance with the laws of the Cayman Islands and those of the source LLC.  

Mourant Ozannes has assisted on a number of mergers of LLCs with Cayman Islands exempted companies, which are effectively redomiciliations, this year. The LLCs in question have been either investment management entities, or entities serving as general partners of investment fund limited partnerships. In the latter cases, the redomiciliation of the general partner LLC has been made in tandem with the re-registration in the Cayman Islands of the relevant fund LP.  Once the draft bill for the creation of a Cayman ELLC is passed, hopefully in early 2015, this will supersede the redomiciliation of LLCs. The draft bill is based on equivalent Delaware LLC legislation and therefore provides for a legal framework that will be familiar to practitioners using Delaware LLCs.  

“Given the position of the Cayman Islands as a leading jurisdiction for fund formation, and that US counsel and US fund promoters have actively been asking for an ELLC solution in the Cayman Islands, we believe that such a vehicle would be attractive to the US funds industry and would enhance Cayman’s position in the fund formation market. Indeed, such a vehicle might be viewed as a premium product.  

“We are of the opinion that a Cayman Islands ELLC would be well suited to operating as a ‘closed ended’ fund – rather than having to look to a Cayman Islands exempted company (which can be constrained by somewhat dated concepts of share capital maintenance) or to a Cayman Islands ELP, which lacks a separate legal personality,” comments Humphries.  Article 13 and the issue of “equivalence”

One other regulatory update that US managers of Cayman funds (and other Caribbean funds) need to be aware of is the ongoing debate on Article 13 of EMIR (European Market Infrastructure Regulation) between European regulators and the US.  In the US, under Dodd-Frank, certain alternative investment funds legally incorporated outside the US – e.g. a Cayman hedge fund – but managed by a US-based manager, are to all intents and purposes considered “US persons”.  Unfortunately, this equivalence does not extend to EMIR. If the European Commission does not regard the fund as being “established” in the US for purposes of Article 13, the upshot is that both the fund and its EU counterparty (if indeed it is trading derivatives with one) would need to comply with both Dodd-Frank and EMIR.

The Managed Funds Association, which represents the global hedge fund industry, has urged the Commission to address this issue swiftly “to facilitate the continued vitality of the global derivatives market and ensure that market participants are not subject to duplicative or conflicting regulations in the EU and US”.  

“The problem with Article 13 is that it contains a proviso which says that at least one of the parties needs to be “established” in a third country to be deemed in compliance with EMIR. Neither an EU bank nor a Cayman fund, for example, is established in the US even though the fund may be a US person under Dodd Frank.

“This is going to be a significant issue with a determination of US equivalence.  I don’t believe that it is fair to simply focus on where the entity in question is legally established. EMIR is subject to a review in 2015 and it may well be that Article 13 faces closer scrutiny because of this strict requirement for establishment as opposed to, say, being regulated as a US person, which would be a more sensible result,” comments Matthew Dening, Managing Partner of Sidley Austin LLP’s London office. 

This is an EMIR issue more than anything else and not something that the Cayman authorities can do much about. Nevertheless, it shows just how far the tentacles of global regulation now extend.

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