Reflections – Page 2

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

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.