Operational Due Diligence

Publication of “Practical Operational Due Diligence on Hedge Funds”

‘Practical Operational Due Diligence on Hedge Funds’ has now been published by John Wiley. To purchase copies of the book and for further information click on the link here.

This publication by the managing partner of Jaitly LLP sets out practical approaches to conducting operational due diligence on hedge funds and seeks to explain why these aspects are important, things to consider when negotiating terms of investment, and attempts to examine what issues and risks might have been unearthed for discussion by a due diligence team, by reviewing 333 case studies.

The case studies are classified by year starting with a number of pre 2000 case studies and reviewing and commenting on a selection of cases between 2000 and 2012 by examining regulatory material and press information available on them at the time.

©Jaitly LLP

Jaitly LLP Report on Fund Costs and Charges Published

Jaitly LLP was commissioned by the Financial Services Consumer Panel to prepare a report on fund costs and charges on collective investment schemes (including unit linked funds used by pension schemes) which was published in November 2014.

For an executive summary of the report click here.

The full report can be accessed here.

The Financial Services Consumer Panel is an independent statutory body established in 1998 to represent the interests of consumers in the development of policy for the regulation of financial services in the UK. The Panel’s foremost task is to advise and challenge the Financial Conduct Authority. Where possible the Panel also seeks to effect beneficial change on a broad range of financial issues that affect the wellbeing of consumers.

©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

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

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.

©Jaitly LLP

An old hobby horse.

Those of you who know me will recognise an old hobby horse. The importance of a fund’s constitutional documents.

There have been a few interesting cases reported from the Cayman and BVI courts that are worth bearing in mind – if for no other reason than to emphasise why any due diligence on a fund cannot be done properly without a thorough reading of the constitutional documents and in particular the articles of association.

I have often been chided for my interest in these documents. Investment teams are quick to point out that these documents are no more than standard templates churned out by lawyers. But they are relevant because they form the basis of the contract between shareholders and the fund. Their significance increases when a member needs to exercise rights to get back investments in the face of suspensions and other impediments that a fund board may put up when an investor is trying to recover their investment.

This importance has been emphasised by the ruling of the Privy Council in a Cayman case that was heard before it on appeal – Culross Global SPC Limited v Strategic Turnaround Master Partnership Limited. The ruling given in December 2010 is relevant because a subsequent ruling in March 2011 in the BVI is not consistent with the Cayman ruling and therefore underlines the importance of understanding what the articles of association say about a redeeming investor’s status in order to determine what rights may exist to recover money.

These cases have revolved around determining the status of a redeeming shareholder. The distinction between whether you are a member or a creditor of a fund determines what rights you may have to enforce the recovery of money owed to you.

Where a shareholder is trying to get out of a fund that is making losses – the member will have a clear interest in trying to minimise its losses by crystallising the amount owed to it and then enforcing its rights as a creditor of the fund in order to be paid a distribution in priority to other members. A creditor typically would be able to enforce its rights by applying to the court for a winding up order against the fund if money owing to the creditor is not paid when the amounts fall due.

In addition, the Privy Council judgement analyses in great detail how the articles of association have been constructed and then looks at a common mechanism used by offshore lawyers to incorporate the prospectus into the articles – which the judges rejected on the facts of this particular case because of the caveats and disclaimers used by the lawyers in the prospectus.

Establishing the status of a redeeming member was also clarified in a case in the BVI but takes a position contrary to the Privy Council decision in the Cayman case. In Westford Special Situations Fund Ltd v Barfield Nominees Limited & Ors the Court of Appeal took a different view from the court of first instance (which had taken an approach similar to the Cayman Privy Council decision) and determined that BVI insolvency law does not recognise a redeeming member as being a creditor with locus for the purposes of applying for the winding up the company even though they may be a creditor of the fund in a wider sense.

This of course can create a difficulty for a redeeming member if they are no longer a member of the company because the articles are often constructed so that upon redemption a member ceases to have any rights as a member but by virtue of this ruling is also not a creditor of the company able to enforce its rights by seeking a winding up of the fund.

Because of the differences in approach in these offshore jurisdictions, investors would do well to ensure that they seek clarification of the position or seek to have the articles amended to ensure that their position and rights of enforcement are expressly articulated as part of the due diligence that they complete.

Amending articles is an expensive business which investment managers will be reluctant to do but it may be even more expensive if the position is unclear and investors have to place themselves at the mercy of the offshore court lottery in order to recover investments.

©Jaitly LLP

Segregating assets – can the wall be a mirage?

When considering the protection of assets a classic response is the requirement to segregate assets. What does this mean in practice? Everyone understands, for example, when buying a house in the UK, that the money that flows through the purchaser and vendor’s solicitors should be segregated as client money – but not many understand what this really means and how sometimes the risk is not in fact mitigated at all. Client money status, express and constructive trusts and segregation can all be complicated areas but the dangers can still be illustrated quite simply.

The same opaqueness to the implications of practical and legal segregation and their associated risks applies to assets held in fund structures too. The usual structure for fund investments is that the fund is a separate entity from that of the manager managing it, and that this separation or segregation helps avoid what is known as co-mingling risk. The irony of course is that sometimes this separation protects the manager far more than it protects the fund and its investors because the manager can introduce a whole range of risks into the fund without placing itself in any jeopardy (other than reputationally) – whether it is to introduce leverage, cross class liability (another form of co-mingling) or jurisdictional risk.

Lets start with leverage and cross class liability – take a fund with two different classes – one with no leverage and another with 2x leverage. If there is cross class liability – not untypical – then on a risk reward basis which is the class to invest in? I would argue the levered class. Why is this so? Lets take an extreme example to illustrate the point. If each class has one shareholder with $100, fully invested – then the NAV of both classes is $100 but the levered class is carrying a liability of $100 against its assets of $200. Lets say the value of the assets falls by 75%. The NAVs are now $25 for the unlevered class and negative $50 for the levered class because the liability for the $100 borrowed remains unchanged. Now lets assume the prime broker or other provider of finance declares a default on the fund because the fall in value of the assets of that magnitude has been defined as an automatic default event in its contract and it exercises its rights on the assets held as collateral. The $50 of assets in the levered class is taken by the prime broker but there is still a $50 dollar shortfall – if there is cross class liability then the $25 in the unlevered class can also be taken by the financier in satisfaction of the debt – either because the prime brokerage agreement allows for it or because the fund then goes into liquidation and the prime broker as the only creditor gets its hands on the remaining $25 as the sole asset of the liquidated fund thereby suffering an overall shortfall of $25 on its original lending. In such a scenario the shareholder in the unlevered class class is unprotected from the liabilities of the levered class, so they may as well benefit from the potential rewards of investing in the levered class if an investment in the fund can really be justified rather than having the illusion of safety from the fig leaf that is the unlevered class.

Of course the response to concerns such as this was to set up segregated liability structures such as Segregated Portfolio Companies in the Cayman and in Ireland. So that then must be the answer to the problem?

If only life were that simple. One of the standard risks that lawyers put in the prospectus of such a segregated portfolio company is that the segregation may not be recognised in a jurisdiction in which the assets are held. Is it a real risk?

The trouble is that the legal segregation is in the country of incorporation – but the assets are invariably not held in those offshore jurisdictions. The assets are held by financing parties in financial centres such as London, New York and Frankfurt. There has been a lot of work and analysis done in the last few years on protecting assets in different jurisdictions from the insolvency of counterparties but the Lehman Brothers Bankhaus AG case in Germany, for example, has thrown open a whole series of uncertainties in Germany on segregation in relation to client monies. France too has its own issues as to how segregation plays out in the event of insolvency – we are therefore far from having proper certainty of outcome for assets managed in these structures which can play out quite differently from what was originally envisaged and which are dependant on the type of investments, liabilities, operation of collateral and different legal rules. And, all of this is before taking into account that a lot of the broking agreements that funds enter into would in any event, more often than not, waive the segregation rights in order to enable assets to be used freely by the broker such as for re-hypothecation.

There is therefore much to be done before asset segregation really works and protects investors from the risk of contamination from other investment strategies and those of the counterparties with whom they are investing. Until that is sorted out, a lot of the so called asset segregation processes will not stand up to scrutiny and investors will remain unprotected at times of trouble and strife.

Good due diligence would examine these underlying arrangements for segregation to highlight the connected risks and not rely on the investment manager’s arrangements to provide adequate safeguards without detailed examination.

©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.