By Simon Gray – Corporate governance has been at the centre of discussions worldwide about the future of alternative fund management and regulation, and nowhere more than in the Cayman Islands.
Over the past few months the jurisdiction has attracted global attention as a result of a notorious case involving grossly negligent conduct by fund directors and media reports suggesting that some individuals based in the islands hold far more directorships than they can reasonably hope to exercise effectively.
In the case of Weavering Macro Fixed Income Fund Limited (In Liquidation) vs. Stefan Peterson and Hans Ekstrom, the Grand Court of the Cayman Islands in August not only handed down an extended statement of the duties and responsibilities of fund directors but made international headlines by awarding damages of USD111m against the two non-executive directors in question for their wilful neglect or default of their duties, which contributed to the fund collapsing with losses of more than USD500m.
In November, the Financial Times added fuel to the flames with an article that claimed a number of Cayman individuals had “built obscenely large portfolios of directorships”, in the words of an interviewee. One director was reported to sit on the board of 567 Cayman entities, nearly all hedge funds, while at least four individuals held at least 100 non-executive directorships and 14 people held more than 70 board positions each.
Industry practitioners argue that the newspaper appears to have wilfully misunderstood the structure of the directorship provider industry that has grown up in Cayman in recent years, in which individual board members are supported by an entire corporate research and IT infrastructure. They also note that the board members censured in the Weavering case were neither professional directors nor based in Cayman.
Nevertheless, the global attention attracted to the issue appears to have persuaded the industry regulator, the Cayman Islands Monetary Authority, that the time has come for a review of the provisions for oversight of whether and how fund directors are carrying out their duties. Whether changes would involve voluntary measures or legal requirements is not yet clear, but one way or the other, regulation is set to become more stringent.
Henry Smith (pictured), global managing partner of law firm Maples and Calder, notes: “Over the past couple of years we have seen much more focus by investors on corporate governance generally in the alternative fund sector. Five or six years ago not too many people would have been concerned about whom the independent directors were, but today we are asked about it a lot. We know from our own statistical database that up to 70 per cent of funds now have independent directors, which from a US perspective is a big shift.”
Paul Harris, chairman of directorship provider International Management Services and president of the Cayman Islands Director Association, argues that the Weavering case made clear that the jurisdiction takes the issue of corporate governance very seriously, as well as emphasising that individuals in other parts of the world will be held accountable for their conduct on the board of Cayman funds.
“The Weavering case involved non-resident directors,” Harris stresses, adding that the court’s comments on what is expected of a hedge fund director in the Cayman Islands were already set out in the Directors Association’s code of conduct. He adds: “The judgement sends a strong warning to non-resident directors to conform to Cayman standards or face the consequences.”
The directors of the Weavering fund, which was set up in 2003 and which was listed and administered in Ireland, were the Swedish-based younger brother and stepfather of the investment manager, Magnus Peterson. According to the court judgement, to cover up trading losses Magnus Peterson created fictitious interest rate swap transactions with a company he had created in the British Virgin Islands that also had Stefan Peterson and Ekstrom as directors.
The fraud unravelled in late 2008 when, in the wake of the Lehman Brothers collapse, the fund received large redemption requests. Despite having received reports from the administrator, PNC, that made clear that the swap counterparty could not pay the sum allegedly owed to the fund, the directors authorised the payment in part of the redemption requests based on a fictitious net asset value. The fund was eventually put into liquidation in March 2009.
The court found that the directors, who were not paid fees, never paid any attention to reports they received from the administrator that would have revealed that the fund was not complying with its investment restrictions, never held board meetings, and rubber-stamped board minutes provided by the investment manager without caring whether the content was true. The damages sum was based on the redemption payments made between the date when the fund should have been terminated in November 2008 and its actual liquidation.
Jon Fowler, head of Maples and Calder’s investment funds group, argues that much of the attention paid to the Weavering case, especially in the US, stemmed from its sensational facts. “It involved egregious conduct by Swedish directors of what was billed by some as a mini-Madoff business, but the judge did take the opportunity to make statements about a range of established common law principles applied in a hedge fund context,” he says.
Don Seymour of DMS Management believes that, far from painting the governance of Cayman funds in a bad light, the judgement is beneficial to the image of the sector. “It clarified one very important issue, which is that directors should perform their work in a professional and business-like manner, and the court went to great lengths to explain what it meant by that,” he says. “It was good news for the professional director industry in Cayman and for firms like DMS.
“It was probably the first time that a court in any common-law jurisdiction had dealt with the issue with regard to the unique circumstances under which hedge funds operate, as opposed to the duties of directors generally. They differ fundamentally from trading companies in that hedge funds operate through delegates whereas trading companies operate through employees. For example, there have been questions for years about the extent to which the director of a hedge fund should be held responsible for the conduct of employees at an administration firm.
“These important questions have now been answered, and the clarity provided by the court is very good for the future growth of the industry. The key thing totake from the Weavering ruling is that anyone who agrees to become a director must perform fully in accordance with the obligations of that company and of the law. A more rigorous focus on how a director actually performs is good for the whole industry and for its stakeholders.”
Some hedge fund practitioners in Cayman say that the issues raised by the media about the number of directorships held by individual professionals are a red herring in that it was not this kind of director whose failings were exposed by the Weavering case. “If the defendants in the case had been Cayman independent directors, in my view the fund blow-up would not have happened,” says Neal Lomax of Mourant Ozannes. “The independent directors I work with are very familiar with their fiduciary duties and responsibilities under Cayman law.”
Lomax says Cayman’s leading directorship service providers are organised in such a way as to manage the number of directorships they hold. “They have a very extensive support staff network that assists each director in fulfilling his or her duties, and a sophisticated computer system that enables them to monitor very closely what the funds are doing,” he says.
“The number of directorships alone does not give a real picture of what a particular individual’s capacity is. If 20 or 30 are within the same family of funds, including feeders and masters, many of the issues coming before the board of directors may be similar or identical. In any case, these firms do not make any secret of how their business model operates. Anyone not comfortable with that model does not have to use them.”
As one of the individuals singled out by the FT, Seymour says: “The real question is what resources the director has to do the job. Obviously there is a limit to what any single person can do, depending on the requirements of the position in question, but you would expect a person like myself, with the ample resources of a firm like DMS at my disposal, to have a much larger capacity than someone working on his own.”
Appleby’s Bryan Hunter notes that most providers of directorship services established in Cayman are already subject to regulation, but that individual directors like the Weavering pair, whether or not located in the jurisdiction, are not.
He adds: “There is a general view that placing a limit on the number of directorships that an individual director may hold is not the way to go. Any number that you choose would be arbitrary and would not take into account factors such as the skills of the director in question, and their capacity to take on additional directorships given the systems and processes in place to support them in their roles.”
Some industry members believe the logical consequence of investor pressure on directors to become involved in day-to-day detail, as opposed to a supervisory role, will be the emergence of institutional directors, on similar lines to the evolution of trustees in the trust industry. “If a director is expected to be an expert in, and examine the detail of the work done, across multiple different disciplines including accounting, legal issues, risk management, compliance and the tracking of investment objectives, can any single individual can provide it all?” asks Fowler.
“Are investors in the industry effectively pushing for an institutional director – in the same way as the evolution in the trust industry a number of years ago, when there was a shift from individuals to corporate trustees with a complete institutional framework behind them? If investors are going to drive directors harder and harder, the natural reaction is for it to become less of an individual game and more one where institutions develop systems and packaged products that together represent an independent directorship. I don’t expect that to come immediately, but it may happen over a few years.”
Lomax is less certain. “Corporate directors have been mooted, but I remain a little sceptical,” he says. “People do like to know exactly which individual is on the board and what their qualifications and experience are. However, I can see how it might appeal to providers of independent directors because it may be easier to justify a corporate structure having a large number of directorships.”
DMS is convinced that the fund governance model will evolve to meet the new expectations on the part of both regulators and investors. Says Seymour: “DMS has prepared for this evolution and is now licensed to offer institutional-quality fund governance services through a subsidiary regulated by CIMA under the Mutual Funds Law.
“Our institutional fund governance service goes beyond simply providing single directors to a fund and is built on the belief that high-quality fund governance is a continuum – a system of checks and balances. Each DMS director is assisted by a specialist team of associate directors and associates who audit every governance transaction with common sense judgment in ways that supplement existing operational risk controls.
“We fully support CIMA’s robust regulatory framework for institutional directors, and as a licensed fund governance service provider the firm maintains strict policies and procedures for independence, risk management, quality assurance, record-keeping, data security and business continuity. Almost all fund service providers including the auditor, administrator and most recently the investment manager, are now regulated, and regulation of fund governance is the next logical step.”