Jaitly LLP – Page 2

Changing American requirements

Hedge funds in the United States have traditionally operated under two exemptions from registration prior to the implementation of the Dodd Frank Act registration requirements which came into force on 30 March 2012 . These exemptions were found in the Investment Company Act 1940.

The first of these exemptions was found in section 3(c)(1) which exempted a fund from registering if its outstanding securities were owned by not more than 100 persons who were accredited persons (having a net worth of more than $1m). This basic exemption was not as simple as it first sounded as there were a number of permutations that could be applied to it.

The second of the exemptions was found in section 3(c)(7) which exempted a fund from registering if its shareholders belonged to a category of investors referred to as Qualified Purchasers which was defined by reference to their wealth whether held individually or through entities. There were also some exceptions to this rule such as knowledgeable employees of the manager. Although section 3(c)(7) does not limit the number of investors the practical effect of SEC regulations and the Exchange Act has meant that the number of investors in such funds was limited to 500 investors in order to avoid more onerous reporting requirements i.e. having more than 500 shareholders would require the fund to register as a public company and provide quarterly reporting.

There was also another relevant exemption in 203 (b) 3 which exempted a manager from making certain reports if they had less than 15 clients – a hedge fund being treated as a single client.

In 2001 the SEC tried to bring in a registration requirement for hedge funds by interpreting the requirements for the definition of what constituted a client. This was overturned when the SEC was challenged in Court (Goldstein v SEC).

The Dodd Frank Act following the credit crisis of 2008 brought back registration for advisers to hedge funds exempting only three categories of advisers: advisers that acted solely to venture capital funds, advisers to private funds with less than $150m in assets under management in the United States and certain foreign advisers without a place of business in the United States. Advisers depending on the assets they manage will be subject to either state registration or registration with the SEC.

Recently another Act the Jumpstart our Business Startups Act is expected to affect the way hedge funds are organised and operate in the United States. This is because the threshold requirement to register as a public company has been increased from 500 to 2,000 shareholders (Title V) which is likely to mean that hedge funds can become much larger than they have been historically. Observers have also noted that Title II of the JOBS Act requires the SEC to adopt rules to eliminate the ban on general solicitation and general advertising when issuers are selling securities to “accredited investors”. Note that this requirement to eliminate the ban does not however appear to extend to the CFTC. It is expected therefore that there will be some more self generated publicity for hedge funds than has historically been the case in the United States.

©Jaitly LLP

Preserving assets

Yet again there is plenty to write about on regulatory developments but it is worth spending a bit of time on the Lehman client money judgement.

The Supreme Court judgement on Lehman Brothers has reached a sensible result for protecting client assets.

Lord Hope described the basic position in English law where “segregation of money into separate bank accounts is not sufficient to establish a proprietary interest in those funds in anyone other than the account holder. A declaration of trust over the balances standing to the credit of the segregated accounts is needed to protect those funds in the event of the firm’s insolvency. Segregation on its own is not enough to provide that protection. Nor is a declaration of trust, in a case where the client’s money has been so mixed in with the firm’s money that it cannot be traced. So segregation is a necessary part of the system. When both elements are present they work together to give the complete protection against the risk of the firm’s insolvency that the client requires.”

These principles were adopted in CASS 7 of the FSA rules creating a statutory trust over client money and providing for segregation of the client money.

The Lehman insolvency gave rise to three questions over the operation of the client money rules:

When does the statutory trust arise
Where a firm fails, is client money that is identifiable in the firm’s house account to be treated as client money or only money that is in the segregated client accounts
Where a firm fails, who has a right to participate in the client money pool i.e. should it be only those clients whose money was held in the segregated client money accounts or should it be all clients who ought to have had their money held in segregated accounts but which may have been in house accounts at the time of failure.

The treatment of client money can potentially give rise to huge problems because there is a reliance on the financial services firm to recognise the funds as client money and then to treat it appropriately. If it does not take the two steps to segregate and declare the funds as client money, then the client is exposed at a time when it needs most protecting in the event of a firm’s failure.

On the first question the Supreme Court found that the statutory trust arose upon receipt of the money. They drew on the Scottish law principles of fiduciary duties owed by an agent rather than on the law of trusts in reaching their conclusion. They determined on the second issue that all money received as client money was client money regardless of whether it was held in house accounts or in client money accounts. On the third issue which was closely related to the second and which a number of the judges considered before reaching their conclusions on the second issue – it was held that distribution of the client money pool should be on a claims basis and not a contributory basis. i.e. all clients that were entitled to have their money segregated were entitled to participate in the client money pool rather than restricting it to those clients whose money had been placed in the segregated client money accounts.

Although there is complex legal reasoning in reaching these conclusions the practical effect of the judgements is a sensible one for clients. Clients are not in a position to assess whether a financial services firm has properly segregated client money that is to be treated as such and a failure on the part of the financial services firm not to segregate the client money should not result in a misfortune for the client.

The judgement means that clients no longer need to take steps to verify that their funds have been properly segregated where a regulated firm is applying the CASS rules to funds held on their behalf as client money. (Something that Jaitly LLP has advised clients in the past to do in order to protect their interests – even though the process of doing so practically was quite difficult.)

The Supreme Court recognised that this was likely to mean a more complex process for the administrators of the Lehman Administration in distributing the client money pool but it means that clients are not faced with an additional burden of verifying that an authorised financial services firm has carried out its obligation to segregate and place money in a client account. A process which was difficult even for sophisticated institutional clients.

A sensible result for protecting and preserving assets that belong to clients.

©Jaitly LLP

Judicial derailment of the SEC settlement process

I have written on a few occasions now about my concerns with the effectiveness of the regulatory approach of the SEC through settlements.

The recently reported proposal of the SEC to settle the case against the two Bear Stearn’s managers highlights how the US judiciary is starting to question its “rubber stamping” role in SEC settlement proceedings.

Reuters have helpfully given access to the transcript of the proceedings before the United States Senior District Judge Frederic Block who asked that the settlement approval process be discussed in open court.

The judge questioned the basis of settlement to which the SEC responded by saying that they were not in a position to award damages. The judge observed “ You had some tough adversaries. They brought you down to your knees, apparently”. The two managers had earlier been acquitted of the criminal charges made against them.

In the proposed Citi settlement Judge Rakoff had questioned the basis on which settlement had been reached.

Senior District Judge Block had earlier asked “[But once again,] am I just a rubber stamp here or is there some inquiry I ought to be making about these provisions? About the fairness of it? Or the reasonableness of it? I’m not so sure I necessarily agree with everything Judge Rakoff wrote, but what should be the Judge’s role when the Judge is being asked to consent to one of these types of things?”

The lawyers representing each of the parties have been asked in this case to prepare letter memoranda for submission to the judge by 21 February in which each party has been asked to consider Judge Rakoff’s standards.

If this trend continues then there is hope that regulatory actions may come with sharper teeth and financial institutions will need to do more than simply consider a regulatory fine as being no more than a cost of doing business.

Effective regulation may require the current SEC approach to settlements to be derailed.

©Jaitly LLP

Registering Cayman Master Funds

On the 22nd of December 2011 following the gazetting of a change to the Mutual Fund Law (2009 Revision) called The Mutual Funds (Amendment) Law 2011 (Law 32 of 2011), certain Master Funds are now required to register with the Cayman Islands Monetary Authority.

This legislation appears to be intended to allay fears over the formation of unregulated entities in the Cayman. Prior to this enactment most Master Funds were able to avoid registration under the Mutual Funds Law because the investors in these funds were feeder funds (rarely more than three) and funds with less than 15 investors were exempt from registration. This meant that the Master Funds operated beneath the Cayman regulatory radar with no requirement for these funds to register or file returns. The legislation attempts to address this and of course creates another income stream in the bargain for the island.

Whilst new funds will need to comply with the registration requirements, existing Master Funds will also need to revisit their structure to establish whether or not they need to register. They have 90 days from the commencement of the law to do so unless the Cayman Government decide to extend the deadline by a further 60 days.

A Master Fund is defined as a mutual fund that is incorporated or established in the Cayman Islands that holds investments and conducts trading activities and has one or more regulated feeder funds. This means that if there is a feeder fund that is regulated by the Cayman Island Monetary Authority in the fund structure then this will create a registration requirement for that fund. A feeder fund is defined as a mutual fund that conducts more than 51% of its investing through another mutual fund. The 15 investor rule will not apply to a Master Fund.

So what does it mean for a fund that meets the new definition of a Master Fund?

A registration fee is payable

A copy of the certificate of Incorporation will need to be filed

If the Master Fund has an offering document – this will need to be filed on registration and updates will need to be filed too. Most Cayman funds incorporate the details of the Master Fund in their Cayman Feeder documents so there should normally be no additional filing requirement.
Where the auditor and administrator of the Master Fund are different to the regulated feeder fund then consent letters from them need to be filed.

A completed Form MF4 will need to be submitted – signed by an Operator – defined in the Mutual Fund Law as being a trustee, general partner or director depending on the legal structure of the fund.

One potentially useful future aspect of the Form MF4, from a due diligence perspective is that the form requires a declaration if the fund has any investors other than the regulated feeder funds to a Master structure – although the way the form is currently drafted the answer will almost always be affirmative because of the US Onshore Limited Partnership Feeder if one exists, but if the form develops over time this declaration may become a useful double check in relation to other investors able to invest directly.

Time to do some form filling and to get that cheque book out again.

©Jaitly LLP

Changing historical perspectives – Regulatory settlements

In May 2010 I wrote about the settlement on the Goldmans case questioning the SEC approach to settlements. Similar issues have now arisen surrounding the SEC settlement on the investigation into Citigroup and its activities in the sub prime market – the difference being that this time it is the judge who was asked to ratify the settlement who is questioning the process.

The Opinion and Order of the District Judge Jed Rakoff dated 28 November 2011 makes interesting reading [ U.S. Securities and Exchange Commission v Citigroup Global Markets Inc 11 Civ.7387 (JSR) United States District Court S.D. New York ] and although his comments are directed in relation to the injunctions that the SEC were seeking against Citigroup as part of the settlement, they are nonetheless important to the overall approach that is increasingly being adopted by other regulators.

The SEC allegation was that when “Citigroup realized in early 2007 that the market for mortgage-backed securities was beginning to weaken, Citigroup created a billion-dollar Fund (known as “Class V Funding III”) that allowed it to dump some dubious assets on misinformed investors. This was accomplished by Citigroup’s misrepresenting that the Fund’s assets were attractive investments rigorously selected by an independent investment adviser, whereas in fact Citigroup had arranged to include in the portfolio a substantial percentage of negatively projected assets and had then taken a short position in those very assets it had helped select.”

Citigroup realised net profits of around $160m by adopting this approach it was alleged.

The judge quoted a parallel complaint against a Citigroup employee where the SEC had alleged in that complaint that “Citigroup knew it would be difficult to place the liabilities of [the Fund] if it disclosed to investors its intention to use the vehicle to short a hand-picked set of [poorly rated assets] …. By contrast, Citigroup knew that representing to investors that an experienced third-party investment adviser had selected the portfolio would facilitate the placement of the [Fund’s] liabilities.” The judge thought this appeared to be tantamount to an allegation of knowing and fraudulent intent but the SEC for reasons of its own chose to charge Citigroup only with negligence, in violation of Sections 17 (a)(2) and (3) of the Securities Act and submitted to the Court the Consent Judgement for approval which included the recitation that Citigroup consented to the entry of the consent judgement without admitting or denying the allegations of the complaint. This consent judgement included permanent restraints enjoining Citigroup and its agents and employees from future violations of sections 17 (a)(2) and (3) of the Securities Act and required Citigroup to disgorge $160m in profits, pay $30m in interest and pay a civil penalty of $95m and to undertake certain internal measures to prevent recurrences of the securities fraud allegedly perpetrated.

The Court decided it was unable to approve the consent judgement “because the Court has not been provided with any proven or admitted facts upon which to exercise even a modest degree of independent judgment.”

The consent judgement needed to fulfil 4 criteria that were set out in SEC v Bank of America Corp of being fair, reasonable, adequate and in the public interest. The SEC in this case tried to argue that the public interest was not part of the applicable standard of judicial review. The judge disagreed because the SEC were seeking an injunction forbidding future violations and asking the Court to enforce prophylactic measures for three years and in his view the Supreme Court had repeatedly made clear that a court cannot grant the extraordinary remedy of injunctive relief without considering the public interest.

The judge came to the conclusion that the consent judgement sought was neither fair, nor reasonable, nor adequate nor in the public interest. Most fundamentally because the SEC did not provided the Court with sufficient evidentiary basis to know whether the requested relief was justified under any of the standards and if the Court were to become a mere handmaiden to a privately negotiated settlement on the basis of unknown facts then the public are deprived of ever knowing the truth in a matter of obvious public importance.

“Here, the S.E.C.’s long-standing policy – hallowed by history, but not by reason – of allowing defendants to enter into Consent Judgments without admitting or denying the underlying allegations, deprives the Court of even the most minimal assurance that the substantial injunctive relief it is being asked to impose has any basis in fact.” The judge noted it was clear that Citigroup intended to contest the SEC’s allegations whereas in contrast the SEC took the position that because Citigroup did not expressly deny the allegations the Court and the public somehow knew the truth of the allegations.

“As for common experience, a consent judgment that does not involve any admissions and that results in only very modest penalties is just as frequently viewed, particularly in the business community, as a cost of doing business imposed by having to maintain a working relationship with a regulatory agency, rather than as any indication of where the real truth lies. This, indeed, is Citigroup’s position in this very case.”

The judge went on to say: “Of course, the policy of accepting settlements without any admissions serves various narrow interests of the parties. In this case, for example, Citigroup was able, without admitting anything, to negotiate a settlement that (a) charges it only with negligence, (b) results in a very modest penalty, (c) imposes the kind of injunctive relief that Citigroup (a recidivist) knew that the S.E.C. had not sought to enforce against any financial institution for at least the last 10 years, see SEC Mem. at 23, and (d) imposes relatively inexpensive prophylactic measures for the next three years. In exchange, Citigroup not only settles what it states was a broad- ranging four-year investigation by the S.E.C. of Citigroup’s mortgage-backed securities offerings, Tr. 27, but also avoids any investors’ relying in any respect on the S.E.C. Consent Judgment in seeking return of their losses. If the allegations of the Complaint are true, this is a very good deal for Citigroup; and, even if they are untrue, it is a mild and modest cost of doing business.

It is harder to discern from the limited information before the Court what the S.E.C. is getting from this settlement other than a quick headline. By the S.E.C.’s own account, Citigroup is a recidivist, SEC Mem. at 21, and yet, in terms of deterrence, the $95 million civil penalty that the Consent Judgment proposes is pocket change to any entity as large as Citigroup. While the S.E.C. claims that it is devoted, not just to the protection of investors but also to helping them recover their losses, the proposed Consent Judgment, in the form submitted to the Court, does not commit the S.E.C. to returning any of the total of $285 million obtained from Citigroup to the defrauded investors but only suggests that the S.E.C. “may” do so. Consent Judgment at 3. In any event, this still leaves the defrauded investors substantially short-changed. To be sure, at oral argument, the S.E.C. reaffirmed its long-standing purported support for private civil actions designed to recoup investors’ losses. Tr. 10. But in actuality, the combination of charging Citigroup only with negligence and then permitting Citigroup to settle without either admitting or denying the allegations deals a double blow to any assistance the defrauded investors might seek to derive from the S.E.C. litigation in attempting to recoup their losses through private litigation, since private investors not only cannot bring securities claims based on negligence, see, e.g., Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976), but also cannot derive any collateral estoppel assistance from Citigroup’s non-admission/non- denial of the S.E.C.’s allegations.”

The judge went on to say that it could not be reasonable to impose substantial relief on the basis of mere allegations, it was not fair because the potential for abuse in imposing penalties on facts that were unproven nor acknowledged were patent. It was not adequate because there was no framework to determine adequacy and it was not in the public interest because the Court was being asked to employ its power and assert its authority when it did not know the facts.

The judge went on to say that “in any case like this that touches on the transparency of financial markets whose gyrations have so depressed our economy and debilitated our lives, there is an overriding public interest in knowing the truth. In much of the world, propaganda reigns, and truth is confined to secretive, fearful whispers. Even in our nation, apologists for suppressing or obscuring the truth may always be found. But the S.E.C., of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges; and if it fails to do so, this Court must not, in the name of deference or convenience, grant judicial enforcement to the agency’s contrivances.”

The SEC intend to appeal this judgement but the principles have wider application to any regulatory agency that adopts an enforcement approach of imposing penalties on the basis that the targets are permitted to avoid admitting or denying the allegations made against them.

Change will only ever come about if large financial institutions are not able to get away with flaunting rules by paying their way through a series of penalties which do not require them to admit or deny the allegations against them.

©Jaitly LLP

Operationalising the AIFMD – professional negligence

We now have ESMA’s technical advice to the European Commission on possible implementing measures for the Alternative Investment Fund Manager’s Directive but there is still plenty of work needed to understand what it all means.

I was particularly interested in how ESMA has approached the requirements for the manager to maintain a form of capital adequacy – whether through the maintenance of own funds or professional indemnity cover to meet the risks arising from professional negligence.

US based hedge fund managers have not needed to worry about the capitalisation of their businesses or for maintaining professional indemnity cover for these risks although some do as a matter of good practice. Others take the view that the size of claims given the assets they manage would make any insurance unrealistic and to the extent they were able to obtain a policy the costs and the deductibles would make it difficult to justify. In the UK investment managers need to be authorised by the Financial Services Authority and need to have adequate capital. This has generally been measured by most managers on the basis of their three month fixed operating costs as being the basis for maintaining a minimum capital requirement.

ESMA appears to be approaching the issue differently for managers authorised under the AIFMD allowing a combination of own funds and professional indemnity insurance to address professional liability risk for liability arising from professional negligence.

Managers need to understand what this means for them.

The basic quantitative rule for the “additional own funds requirement” for liability risk is equal to 0.01% of the value of the portfolios of alternative investment funds managed by the manager. This would be calculated at the end of each year. Member States will be permitted to lower the requirement to 0.008% provided that the manager can demonstrate based on its historical loss data over a minimum of three years that liability risk as defined is adequately captured. Member States can also raise the own fund requirement if they are not sufficient to capture liability risk arising from professional negligence.

The risks it is intended to cover are divided into two main groups:

(a) Risks in relation to investors, products and business practice
(b) Risks in relation to business disruption, system failures and process management

An alternative to maintaining own funds is to take out and maintain a professional indemnity insurance policy that meets certain requirements and with a minimum cover of the higher of :

0.75% of the amount by which the value of the portfolio of the manager exceeds €250 million up to a maximum of €20 million or
€2 million

The minimum coverage of the insurance for all claims in aggregate per year must be at least equal to the higher of:

1% of the amount by which the value of the portfolio exceeds €250 million up to a maximum of €25 million or
€2.5 million

Own funds can be combined with professional indemnity cover to meet the requirements set out provided that the value of assets covered by the managers own funds is not less than 10% and the minimum limits for the insurance cover will apply after adjusting them on a pro rata basis.

But it is not just European managers that need to start addressing these requirements, other managers looking to distribute products into Europe need to start thinking about the impact of these regulations and how it may affect them going forward.

©Jaitly LLP

Inconsistency in Regulation

En route to London from Geneva at the end of the GAIM Ops Conference last Friday, I remembered how four years ago when I used to fly regularly on business to Geneva I was always amused by the inconsistency of airport security.

At Geneva in common with other airports the queues for security are always a major bottleneck. Nothing metallic, nothing sharp. A body search if the detector signals the metal in your belt too much or the steel toe caps in your shoes unacceptable. Fair enough – we all need to feel safe. Mercifully they don’t bother with the pointless rigmarole of the liquids rule of British airports when you can buy plenty of inflammable liquids duty free air side. Once you have been through all of that, had the nail file on your nail clippers snapped off and consigned for recycling as scrap metal and assured the security guards that your blunted metal collar bones were not weapons, you emerge at the other end of security duly sanitised and safe. There in front of you would be the ubiquitous array of duty free shopping and what always caught my eye was the display of Swiss Army knives on sale. Yes – Swiss Army knives for sale, after the security checks, air side. Not behind a secure cabinet but piled high on display hooks available for handling and inspection by all and sundry………!

One evening after a particularly inconvenient security check process, I saw a British Airways captain browsing in the shop with the Swiss Army knives and when I pointed out the futility of the security checks when these were on sale, he simply laughed and said when one thought of all the damage one could do with items freely available on the aircraft alone – Swiss Army knives were the least of his worries.

So four years on, having gone through the formalities of security checking, I thought I would see if the shop was still there and indeed it was, as were the knives – albeit with a much wider choice in styles and sizes. But they had introduced an important restriction – it was now available for sale only on direct flights and additionally when I questioned the shop assistant she assured me that the Swiss Army knife versions with serrated edges were the ones not available air side because they were the really dangerous knives! Lets hope that they don’t have too many incidents of shop lifting either.

With that reassurance and the announcement of a delayed flight and suppressing the urge to buy a knife and test whether hoards of security staff would descend upon me, I thought I would spend some time reading the technical call for advice on level 2 implementation of the AIFMD. I assure you it is good bed time reading.

I thought I would cover Part II on the Depositary but I think the draughtsman for Article 21 suffers from the same Swiss Army knife syndrome of the Geneva airport security system.

Functionally and hierarchically separating a depositary function from prime brokerage does not really solve any problems. In fact it misses the risk altogether in my view – and the fact that you can delegate the custody tasks anyway simply takes away with one hand and gives back with the other. Perhaps the European regulators are on their own mission to stimulate the economy through a requirement for professional advice! The risk that they should focus upon is the operation of collateral when there is leverage or other forms of borrowing. Most assets will not be held by a depositary – they will be held by prime brokers as collateral and will be available generally for re-hypothecation. What this means is that for every $100 lent the prime broker will hold around $140 of fund assets as collateral. It is how that is managed and realised and how the segregation obligation is implemented around the unencumbered assets that is far more important – even when you are looking at a Lehman style situation – than some of the things proposed by the regulators. Having a depositary does not make the assets safer – it is what can and cannot be done with the assets that determines their safety. Lenders will not lend unless they are protected against a borrowers default – and how a lender exercises those rights is far more important than having the assets sit with a third party when they can be collateralised.

Those involved in the industry really do need to engage with the regulators to help them understand the issues so that we get sensible, consistent and effective regulation to create a healthier industry – but with all this red tape you will probably need to buy that Swiss Army knife to cut a clear path through it all. It would at least be some consolation that the knife could be duty free.

©Jaitly LLP

Dark pools and shadow banking

The UK Independent Banking Commission has issued its final report and made its final recommendations. These recommendations essentially involve an enhanced capital adequacy and loss absorption regime combined with ring fencing between the retail and investment banking businesses.

This made me think about whether there were any implications for operational due diligence teams reviewing hedge funds. The edges between private equity, hedge funds and banks have become increasingly blurred and some of the issues that policy makers are grappling with have an impact on hedge fund risks. These hedge funds which replicate the activities of banks through the credit transactions they enter into, can effectively be shadow banks operating away from the regulatory restrictions imposed on banks taking deposits. They need attention when investors make investment decisions.

The transparency issues around hedge funds potentially operating as shadow banks lead me to think about transparency generally around trading as there is also the issue of how price discovery works on large trades when trading is done through dark pools. These are trading resources that enable trades to be entered into anonymously and have become an increasing feature of trading since 2008. A number of exchanges have dark pools, a number of broker dealers provide them and there are even aggregators of these pools.

Shadow banking and dark pools by their very description are less transparent worlds – and investors do need to understand the implications and risks created by these two quite different areas.

Where a hedge fund is operating as a quasi bank because it is involved in lending, leverage and credit intermediation or other forms of structured credit then the risks are similar to those for banks. These credit strategies create similar issues to those of banks – issues such as loss absorbency and ring fencing to protect different classes of shareholders from cross contamination. Banks are used to applying recovery methods in lending situations and build this into their business models and lending decisions. Hedge funds may not have the same structural support for recovery situations and an operational due diligence review needs to understand the capabilities of the fund to do this. Structural depth to handle this will be critical in reviewing operational risks of a hedge fund that is involved in credit transactions or shadow banking activity. The implications of regulatory arbitrage and regulatory action also need to be considered. These are not risks just borne by an investment manager – investors directly bear these risks through the indemnity the hedge fund gives to its investment manager. That indemnity makes it critical for an investor to understand the potential regulatory risks of the fund’s activities.

Dark pools have an important role to play when a fund does not wish to expose itself to market moves against it because the market is aware of its activities – but this opacity and anonymity creates its own problems for price discovery and transparency. These risks need to be understood. Most of the major broker dealers provide dark pool facilities but there is still much to be understood about them by investors and the risks they present. Just because a fund uses electronic trading platforms does not mean that there will be good price and volume transparency. This has implications for an operational risk review of a fund. The exposure a fund has to information leakage on its activities, price manipulation, the reputation of the provider of the dark pool it uses, any aggregators that may be used and what the risks may be from high frequency and algorithmic traders all need to be considered.

As regulators work to protect structures and create transparency – other structures spring up through regulatory arbitrage or through protective mechanisms where the transparency itself creates risks for the operation of the fund.

Dark Pools and Shadow Banking activity are just two examples of evolving fund activity that create a need to look afresh at the changing operational risks of hedge fund activity.

©Jaitly LLP

The Weavering case against its directors

The liquidators of Weavering Macro Fixed Income Fund Limited have a result in the Grand Court of the Cayman Islands. On the 26th of August 2011 in a 37 page judgement Mr Justice Andrew Jones QC gave judgement against each of the two directors of the fund in the sum of US$ 111 million plus costs – to be taxed if not agreed.

The judgement is important because it places a spot light on 4 fundamental principles in relation to hedge fund directors that need to be carefully considered by both investors and fund directors alike.

The first important point of principle is that fund directors need to be independent and should not act simply as an extension of the will of the investment manager. They need to discharge their duties in a manner that is in the interests of investors. Clearly directors cannot ignore the commercial realities that give the investment manager the power to influence decisions, but directors should not act blindly on the instructions of an investment manager. The judgement should cause investors to reflect on nominating their own boards of directors to ensure that there is independence from the will of the investment manager.

The second principle is that the range of duties and the manner in which they are discharged by directors should reflect the arrangements of the fund and the directors general fiduciary duties. There are many professional directors of offshore hedge funds that would fail to meet a number of the standards articulated by Mr Justice Jones QC in his judgement. The failings will often arise due to a reluctance on the part of directors to challenge the will of the investment manager who ultimately control appointments to and removal from the board. Professional directors who rely on the income stream from multiple appointments by a manager will wish to accommodate the wishes of an investment manager to protect that income stream. In my view this is another reason for investors to be involved in the appointment of fund directors. I was both amused and appalled by the reference in the judgement to the resolution appointing PriceWaterhouseCoopers as auditors and Fortis Fund Services (Isle of Man) Ltd as already having been appointed administrator to the fund when in fact subsequently, the Cayman and Irish firms of Ernst & Young were appointed as auditors and PFPC International Ltd was appointed the administrator. It does happen, because in reality it is the investment manager that drives these decisions. The directors more often than not, simply go along with these appointments.

The third principle is that the indemnities given to directors on hedge funds need careful examination by investors. The Weavering fund indemnity was worded so that the indemnity carved out wilful neglect or default. The judge was therefore required to determine whether the actions of the directors constituted wilful neglect or default in order to determine whether they were (1) liable and therefore (2) in being liable were not able to rely on the indemnity. In doing so the judge relied on the test adopted by Harre J (in Prospect Properties Limited (in Liquidation) v McNeill [1990-91] CILR 171 ) based on the 1925 decision by Romer J in Re City Equitable Fire Insurance to set out two limbs to determine what was wilful neglect or default:

(a) knowing and intentional breach of duty or

(b) acting recklessly, not caring whether or not the omission is a breach of duty.

The case against the directors according to the judge was “fairly and squarely” under the first limb of the test and the judge found against them on the grounds that “they did nothing”. However there are many funds with indemnities that do not have such carve outs or where the exculpatory clauses and carve outs do not match the carve outs of the indemnity clauses. The judgement is quite clear in accepting “that these directors are entitled to rely upon the exculpatory provision[s]”. In my experience these clauses are rarely given enough attention by investors.

The fourth and final principle is to reflect on the extent to which investors will recover any money even though an action is successful. The liquidators have succeeded in an action against the directors but whether the directors are in a position to meet the judgement against them of US$ 111 million plus costs will depend on their personal worth and the existence of insurance or other assets.

The judgement itself should be compulsory reading for all directors of funds.

©Jaitly LLP

Weeding out fiction from fact

A fair amount of time this month has been spent analysing historical blow ups in the world of hedge funds. Having identified over 250 failures of one kind or another it has been interesting to see what material is easily available on each in the public domain and what themes have emerged.

The differences between the information that is readily available for failures in the United States contrasted with those in the UK is interesting too. It feels a lot easier to get factual and anecdotal information on US failures – partly because a large number of fraudulent cases, which are U.S. based, have involved SEC complaints and court judgements. That makes analysis relatively easy. It seems surprising that there is so much more information available in the U.S. given their litigious nature, when contrasted with the UK where the availability of information in the public domain, other than anecdotal press comment, feels far more difficult to obtain. There seems a much greater air of secrecy. Even the insolvency cases based out of Australia seem to have a rich seam of information in the public domain with letters and reports to investors all readily available on the practitioner’s websites.

I have examined 30 failures to date so although a fair amount of the journey still remains to be travelled, some common themes seem to have emerged quite early.

The first is that the instances of fraudulent activity I have looked at so far seem to indicate that those hedge fund managers accused of fraud often had some sort of form in their past . In a number of cases this information was in the public domain and was capable of being identified by investors through basic background enquiries. In the case of institutional investors there is little excuse not to have done this. Making judgements on past events can be difficult, however even if one is to take a forgiving view, then it is important at the very least to have built in safeguards against the highlighted red flags or the possible mind set. Investors often seem reluctant to do so.

The second theme is that liquidity is often ignored by both manager and investor alike. Managers seem to take an optimistic view of the risks. Investors rarely consider portfolio liquidity other than in the context of redemption terms available to them and portfolio marketability and often ignore the risks associated with leverage. It is often forgotten that anyone who lends money or provides finance protects themselves first and it is therefore essential that investors understand the risks to the fund and their money that arise in such an environment. The lender is more often than not likely to get their money back well before an investor. In a highly leveraged environment an investor is at the bottom of the order of priority of payments.

The third theme is that information on the funds, their investment strategy and the manager is often inconsistent with the information given to investors who rarely monitor developments in the manager’s activities other than the performance reports. The inconsistencies are often identifiable before investment, and where they are not, the lack of independent checks on reporting are all too evident. There needs to be a real will to verify information provided by managers. All too often investors are prepared to accept the written word without considering the extent to which there has been any independent checking of that information.

Of course there are other themes that we cannot get away from either – there will always be people who are crooks, mistakes invariably do happen and it is human nature to try and cover up a problem and work it out behind the scenes in the hope that it will not upset the apple cart. From what I have seen and heard in my years in the world of finance, hiding problems in the hope of resolving them quietly without discovery by others often exacerbates the situation and the transition from operational mistake to fraud can be a very quick and dangerous one. Light is a great antiseptic.

Hindsight holds lessons for anyone involved in hedge fund due diligence, indeed any form of business due diligence. Always look at the individuals who control and manage your money. Look at the weaknesses of the business such as from borrowing, margin calls and concentration risk. Look at the problems that might threaten a businesses’ existence and how they might arise, what controls there are around preventing such potential problems, who would identify the problems as they arose, who would resolve them and who would oversee the entire process. Independent scrutiny is important in all of these matters. Above all verify, and, where there are inconsistencies remember that it is good practice to err on the side of caution.

Often, the problems that investors got caught in were ascertainable at least in the form of red flags prior to investment, which more often than not were ignored, if they were at all sought and identified in the first place.

Weeding out fiction from fact is what the due diligence process should achieve.