Category: Alternatives

‘On the beach’ directors

The private sector consultation by the Cayman Islands Monetary Authority (CIMA) in January and the concurrent corporate governance industry survey is an attempt by the Cayman Island’s authorities to address some of the criticisms directed at those who accept appointments as directors of Cayman domiciled funds.

Many other jurisdictions appear to have updated their governance codes, guidance and related laws following the financial crisis.  CIMA’s proposals which are long overdue are summarised below:

  1. To extend the Statement of Guidance on Corporate Governance to all registrants regulated by CIMA.   There are no surprises in the guidance.  They cover the responsibilities of the board, director’s duties, documentation, relations with CIMA, risk management and strategic objectives and the use of sub-committees
  2. The creation of a public database operated and controlled by CIMA which will provide the names of the directors of the regulated entity and its registered address
  3. Application of the Companies Management Law to extend to all who offer, provide or arrange others to act as directors, or to persons who themselves act as directors and do so for six or more entities and for profit or reward.
  4. All directors who are not already approved as directors of licensees or via the professional director route will be required to register with CIMA

The corporate governance survey that has been commissioned seeks views on limiting the number of directorships held, 

CIMA has also indicated that it intends to consult on corporate directorships in the future.

It will be interesting to see the responses from the various associations on the island that have been consulted.

Fund governance will always be difficult until investors get involved in the appointment decisions and make clear what they really want from fund governance.   There is a reluctance on the part of many investors to get involved in the governance processes for a variety of reasons.  To a large extent the Cayman industry has developed simply as a response to investor demand to ‘pile em high and sell em cheap.’  Despite that there are many experienced and reputable directors operating on the island.  Experienced directors will reasonably wish to be remunerated for the time they spend on a fund.  Limiting the number of directorships will inevitably push the price of a directorship up.  What the reasonable expectations of a professional director are, will influence the pricing based on supply and demand and whether they can invest in systems and processes that allow them to remain on top of the issues they need to consider on each appointment they accept.

The public database may just begin to start influencing the thought process by shedding light on the extent to which there is a real problem – it may even result in the market self regulating away from those with excessive appointments – but we are still a million miles away from any major sea change in governance processes.  Until then, there will still be some who will face the accusation of being ‘on the beach’ directors.  

The consultation runs to the 18th of March 2013.

©Jaitly LLP

Monitoring conflicts of Interest

Financial Services have lost a lot of credibility since 2007 some of which can be attributed to their failure to manage conflicts of interest.  That failure reflects unfairly on the many in financial services who strive to work decently and fairly and is something senior management in these businesses must take responsibility for.

Conflicts of interest are a fact of life and if recognised and managed properly can avoid many of the problems that have been the cause for criticism.   Recent regulatory action against some of the big names in financial services both in the UK and US highlight that just because entities are regulated does not mean that they necessarily behave appropriately.  Nor does ‘big’ give any indication of respectable behaviour – indeed the reverse might be a justifiable conclusion.

Yesterday the Financial Times reported on a study on mutual fund families conducted by researchers Goncalves-Pinto and Schmidt at the National University of Singapore and Emory University respectively, which reviews how cross trades occur in funds managed by the same investment manager.  Often the ability for such transactions to occur will be of benefit to investors in both the buying and selling funds, but this may not always be the case where the manager is forced to look for liquidity to meet redemption requests when the assets in the portfolio are illiquid (and difficult to value).  We have in earlier published Reflections looked at how this can happen in a fund of hedge funds  where inflows into one vehicle can be used to meet the liquidity requirements arising from outflows in another vehicle.  In such a scenario the cross trade may not necessarily be in the best interests of the subscribing investor but it helps the investment manager preserve its reputation with the redeeming shareholder at the expense of the incoming investor in an unrelated fund.

The evidence on the failures to manage these conflicts of interest continue to mount.

In November this year the UK Financial Services Authority (FSA) published a paper called “Conflicts of interest between asset managers and their customers:  Identifying and mitigating the risks.”  This looked at a few specific areas that are worthy of examination by any investor looking to invest money with an investment manager:

  • How firms identified and controlled conflicts of interest;
  • How firms managed the purchase of research and trade execution services on behalf of customers;
  • How firms managed gifts and entertainment;
  • How firms ensured customers have equal access to all suitable investment opportunities;
  • How firms managed personal dealing by employees; and
  • How firms allocated the cost of errors between themselves and their customers.

The work done by the FSA was in the form of a thematic review of a selection of asset management firms visited between June 2011 and February 2012.  The FSA concluded that “most of the firms visited could not demonstrate that customers avoid inappropriate costs and have fair access to all suitable investment opportunities.”  That is a worrying statement given that these firms are obliged to observe rules such as on treating customers fairly.   Yet it is not altogether surprising, given the attitudes of  some boards in financial services to regulatory fines being nothing more than a cost of remaining in business.  

Some of these firms had not even reviewed their conflict of interest arrangements since 2007 which also begs the question as to what their compliance departments had been doing following the credit crisis and the headline regulatory actions that had occurred since?  The suspicion that asset managers are reverting back to bad old habits is hard to overcome in the face of such evidence.

The FSA has asked the boards of asset management firms in the UK to discuss the findings of the FSA paper and to then complete and return to the FSA an attestation by 28 February 2013 which confirms that the firm’s arrangements are sufficient to ensure that the firm manages conflicts of interest effectively and in compliance with the FSA rules.  

Of course all firms are likely to comply with the FSA requirement.  But a regulator’s demands will not change attitudes on their own.  A firm’s culture – as the FSA points out – is central to the firm identifying and genuinely managing conflicts of interest.   But it also requires investors to actively demand evidence on these matters and to not accept asset managers assurances at face value.  That needs institutional investors with some determination to ensure that matters are set right and managed properly.

The standards of control over payments from customers assets are rarely the same as the standards of control asset managers exercise over payments made from the asset manager’s own resources.  Investors need to ensure that they understand what is being paid for with their assets.

Personal dealing policies and gifts and entertainment are generally better managed as conflicts of interest.

Investors should question how asset managers allocate trades between different clients and how cross trading is controlled between funds they manage.  The FSA has reported that it took enforcement action against a firm that had traded for one fund in order to ease the liquidity problems faced by another fund.  My own experience and the university research referred to above indicates that this issue is a lot more widespread than the regulatory action against one firm would suggest.

The FSA also noted the practice particularly amongst hedge fund managers of using contractual limitations for liability to customers from errors in the absence of gross negligence and for not reporting these and collecting information on them.  Of course under English law gross negligence is considered a “vituperative epithet”.  The FSA note that repeatedly making the same error or similar errors might itself amount to gross negligence.  The standard applied in English law to such a test may not be quite what the asset manager thinks they might be able to get away with.

So there is a lot that investors should be thinking about when it comes to their investment manager managing conflicts of interest.  Notwithstanding the regulated nature of investment management it is worth investors continuing to monitor how investment managers identify, report and manage these conflicts.

©Jaitly LLP

The City’s word

As news of the swingeing fines against Barclays Bank Plc have emerged, accompanied by press and political  comment, the City’s word needs ever increasing scrutiny.

LIBOR and EURIBOR rates are based on submissions from a number of banks that are then collated using a methodology that uses an average of those rates once the outlier rates that have been submitted have been eliminated.  These rates set international benchmarks for borrowing in the City, in international financial markets and for interest rate derivatives.  Reliance on these rates is fundamental to the operation of many financial contracts around the world.

To give some idea of the enormity of the transactions that rely on these rates the Financial Services Authority in its final notice to Barclays notes that “the notional amount outstanding of OTC interest rate derivatives contracts in the first half of 2011 has been estimated at 554 trillion US dollars. The total value of [the] volume of short term interest rate contracts traded on LIFFE in London in 2011 was 477 trillion euro including over 241 trillion euro relating to the three month EURIBOR futures contract (the fourth largest interest rate futures contract by volume in the world).”

The mechanisms for its calculation relied on institutions being transparent about the rates available to them.  The final notice describes how the team submitting the rates on behalf of Barclays took into account requests from their derivative trading teams and even outside traders to influence the submissions they made on behalf of Barclays.  The bank also took into account its own liquidity problems during the financial crisis to influence its submissions.  The full details (click here for a link)  in the final notice of the FSA highlight the level of complacence that existed in the process even when these matters were being raised with compliance teams and external agencies such as the FSA itself. 

What this regulatory action highlights yet again is the huge reluctance of large financial institutions to question the rights and wrongs of what has become market practice or customary modes of behaviour.  It takes a brave person to challenge it, even when they are in a compliance or risk role.  Attending courses on ethics is never sufficient to create a change in culture which challenges and examines right from wrong and takes pride in doing so.  Barclays is a profit making institution – an £85m fine reduced to £59.5m for cooperation is hardly going to break the bank even though its reputation is bound to take a severe knock.  The value of its shares and regulatory capital requirement will be affected (I am a small shareholder, so I see it first hand).   Even additional fines from across the Atlantic by the US regulators will not make a debilitating financial dent to its pocket. It will be regarded as a cost of doing business – even  a cost of surviving, in the face of the meltdown in the financial markets.   At the cost of a few heads that will roll, it will survive the publicity. So will the other banks, who as sure as night follows day will not be guiltless of breaches, as is evident from the other regulatory actions and Barclay’s complaints.  Complaints made whilst remaining silent about some of its own activities despite the extensive cooperation it subsequently gave to regulators.

In the meantime what should one make of the City’s word when it reports numbers such as those relating to LIBOR?  Increasing regulation is hardly the answer.  Large compliance departments have evidently not provided a solution either.    The regulatory action itself has taken years to investigate and crystallise and can hardly be regarded as timely intervention.  Another public enquiry perhaps?  More words and the rattling of cages?  If ghosts past are anything to go by, they seem to be loud and empty vessels.  Can there ever be a practical solution that neatly and transparently balances the competing interests?

A business culture where independent challenge is encouraged and accepted as healthy and not career limiting is much more likely to be productive in enhancing the City’s word as its bond.   That is more likely to result in an environment where it is safe to question right and wrong and to arrive at reasonable, transparent solutions, rather than be forced to be a whistleblower with all its consequences on a career.  To achieve such a culture is a real challenge and much, much easier said than done.  But it has to be the gauntlet that the City’s institutions should be prepared to take up because it is essential that they are trusted and survive.

©Jaitly LLP

Taking a punt on risk and regulation

I spent an interesting morning in Cambridge yesterday along with some other practitioners talking to a postgraduate class at the Judge Business School  about risk.  At the end of my session I was asked whether all the incoming regulations would improve the risk environment on funds.  The answer must be ‘no’ but I have been debating it ever since and indeed our discussions continued afterwards over a sandwich.  Why must the answer be ‘no’?  After all, the regulations are trying to address how risk might be mitigated and disclosed.  Culture however is fundamental to the mitigation of risk.  To the extent that there are ways around rules and regulations – people will find them if that is what the culture encourages.

Lets just look at presentations done by financial services practitioners.  The rules require authorised firms to have a series of disclosures and warnings on presentations that may be construed as financial promotion.  Compliance departments require these disclosures and warnings to appear on presentations.  I find it fascinating (sad though it may be) to see how these disclosures and warnings are dealt with by different people.

Should the warnings be at the start of the presentation or at the end?  How much time should be given on that warning slide – should you talk to the warnings highlighted or is it enough to just flick through that slide?  Does anyone really pay any attention to those disclosures or are they simply ignored and accepted as part of the landscape?  Would they really stop an investor from making a decision to invest in a product or strategy?

For example the warning we are all familiar with is that past performance on an investment is not a guide to future performance.  We all accept that and generally even understand it.  But does that statement really bear further scrutiny?  Of course we buy on past performance.  It is the whole point of reporting and analysing performance numbers.   I don’t know of anyone that has invested in a manager who has consistently reported losses, yet past performance is not a guide to future performance.  Such funds would be quietly closed down and buried as no one would invest in them.  Why do funds mushroom in size?  Because marketing departments trumpet the successes of the fund encouraging others to participate in that success.  

So despite the warning which we all accept as being correct, investors generally do invest on past performance as being a pretty good indicator of future performance – because although nobody really knows how a manager will perform in the future – it would take a brave investor to invest with a manager that was reporting consistent losses.  Indeed institutional investors will generally not invest with a manager with less than 3 years track record.  Perhaps I should rephrase that last sentence more accurately – institutional investors will generally not invest with a manager with less than three years track record of predominantly successful performance – otherwise that manager would not see the light of day – it would be a clever  salesman who could achieve sales on a fund with a poor three year track record.   Yet past performance we are told – and accept – is not a guide to future performance?

Does that mean the disclosure is wrong?  We all accept that it is a reasonable statement, yet investment behaviour does not support it.  Does that mean that investors are simply taking a punt on the risk despite the regulatory requirement that highlights that the premise of the decision may not be a safe one?  Is it because the measure may be one of the few that are readily understood in what is otherwise extremely uncertain decision making? 

Regulation is more often than not a reaction to problems that have occurred.   Regulators need evidence of a problem or market failure to justify the introduction of regulations.  That often means that risk management is backward looking rather than trying to look ahead at what might still go wrong.  The emphasis is to fix what has gone wrong in the past – as there is evidence to justify the stance.  That is regulation responding to risk.  It is understandable but it does mean that regulation therefore is often two steps behind and risk management a step behind the next real problem that is about to occur.  In the meantime all that market participants can take a punt on is that regulation is addressing the risks that have occurred even if none of us can forecast where the next problem lies.  Proper risk management requires the right culture to operate in.  No amount of regulation can ever change the culture of an organisation unless it is regulated out of existence.

©Jaitly LLP

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:

  1. When does the statutory trust arise
  2. 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
  3. 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

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

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

Regulation in bloom – investors beware……

Regulation in the fund industry is alive and well and while things look much rosier in the regulatory garden than ever before – regulation is not going to deliver the panacea that some investors hope for.  This is not a new view – whether it is a focus on AIFMD, capital adequacy, UCITS IV or Dodd Frank reforms – none deliver an alternative to detailed investor due diligence or even to vastly improved governance standards in the industry.  This can only be done by greater investor involvement.

Good governance is an essential add on to proper due diligence when investors make investment decisions and should be viewed as something to be looked at together with the due diligence process as no amount of due diligence can deal with the pressures of ongoing decision making which need to be made with the interests of the investors at the forefront and which can only be delivered through good governance structures which are independent of the investment managers.

But even good governance structures need checks and balances and members need to take care about the slow but relentless erosion of their ability to have a say in matters relating to their money particularly where the board is not independent and investors have a limited say in who can be appointed as directors to their funds.  When things are going well – this is never an issue – but investors do need their own people when things go wrong and backs are against a wall.

Investors who have done their due diligence will be aware that they already have very little say in the governance of the funds that house their money once they have invested unless there are suitably written material adverse change clauses in the articles of association of their fund that protect them from changes when the fund is under stress.  Non voting preference shares (the normal way investors hold their interests in funds) mean that control on fund matters is essentially a matter for investment manager nominees appointed as directors.   

What little rights that did exist continue to potentially be eroded further and members of funds that hold such shares need to beware and ensure that directors do act in their interests.  The Cayman Islands have recently published the Companies (Amendment) Law 2011 to modernise and clarify certain aspects of Cayman Company law – but with it have come potential dangers for members who have not done their homework properly and where directors may have to deal with the pressures of conflicts of interests and where independence may take on greater significance.

An example of this is in section 8 (b) which adds a paragraph (da) to the principal Law in relation to the provisions for redemption and repurchase of shares – on the face of it just a simplification.  Previously how shares were redeemed needed to be authorised by the company’s articles of association or approved by shareholder resolution (s 37 (3)(d) of the Companies Law (2010 Revision).  It is true that the way this was set out was not always ideal or clear, but the Companies (Amendment) Law 2011 (8)(b) now allows the articles of association or a resolution of the company to delegate to the directors of the company authority to determine the manner or any of the terms of any such redemption and repurchase – thereby cutting out the shareholders involvement.  In such a scenario the existence of a well drafted material adverse change clause in the articles of association becomes even more important than ever before.  But it is not enough to take comfort that such a clause exists.  It is important to understand how polls can be demanded at the meeting, what constitutes a quorum for such a meeting and what the mechanics of instituting the change would be and that the investors are comfortable with the directors making these decisions and are able to have a say in who they are.

I have pointed out previously that investors themselves are not blameless for the current position as managers and fund administrators often struggle to get investors involved properly in fund governance issues when changes are required and so expediency does drive them to ensure that things can be done by the directors without having to rely on investor involvement – but as directors are given greater powers, the need for investors to determine who their fund directors are becomes ever more important.

So whilst the regulatory environment grows for funds, investors still need to beware of relying too much on the regulatory environment protecting them from some of the risks that may arise such as from potential conflicts of interest.

©Jaitly LLP