A Governance Reversal? – Cayman Appeals Court Weavering Decision Turns Good Governance Bad

The Cayman islands was doing so well lately in refurbishing its image.  With the recent Cayman Islands Corporate Governance Survey, and director licensing initiatives it looked as though investors were finally about to have some real form of director oversight, and perhaps dare we say it even material accountability? A Governance Reversal?   Cayman Appeals Court Weavering Decision Turns Good Governance Bad

Well it seems this was too good to be true. At least that’s what’s the Cayman Islands court system effectively stated with its most recent decision in the Weavering case. As a quick recap, in this case two directors of the Weavering Macro Fixed Income Fund were originally determined by a Cayman Court to have been negligent in the oversight of the fund.

This was a problem for the directors because the fund was later found to effectively be fraud, and the firm’s founder Magnus Peterson was recently sentenced to 13 years in jail. Furthermore, by being found negligent the directors were on the hook for a judgment of approximately $100 million USD.

As expected, they appealed the ruling and the Cayman Court agreed with them. Without delving too much into the legal technicalities in this case (i.e. – what constitutes willful negligence versus default), one thing is clear from this decision – this latest development in the case represents a major step backwards for hedge fund governance. A Governance Reversal?   Cayman Appeals Court Weavering Decision Turns Good Governance Bad

Aren’t Directors Protected By Indemnification Clauses?

To be clear, issues of negligence and associated terms, in particular willful negligence as it applies to the directors in the Weavering case, are related to the broader area of director indemnification.

Despite minor difference in indemnification standards among different jurisdictions, the standard of negligence is effectively set by the hedge fund themselves in their offering documents. An indemnification at a standard of “willful negligence” is quite common in the hedge fund industry.  However, in this case the Cayman Court of Appeals disagreed with the UK Court, which found the directors to be negligent. Further deviations the interpretation of the standard of terms such as willful negligence between jurisdictions will likely further develop going forward only complicating the issue even more.

Practically, this most recent Cayman Court decision effectively outlines that the directors of Weavering were not “willfully negligent.” Therefore, it is perhaps even more concerning that this sets a legal precedent for not only Cayman funds, but also potentially sets the evidentiary bar quite high to show a case of actual negligence for funds outside of the Caymans.

From the perspective of investors it further widens the gap between the promise of what directors should be doing to implement rigorous fund oversight and the realities of their lack of liability for failing to do so.Grand Court A Governance Reversal?   Cayman Appeals Court Weavering Decision Turns Good Governance Bad

Interestingly in an interview for his new book, Hedge Fund Governance: Evaluating Oversight, Independence and Conflicts (Academic Press, 2014), Corgentum Consulting Managing Partner, Jason Scharfman, interviewed a representative of the Cayman Islands Monetary Authority (CIMA) about the impact on governance and director liability of the Weavering decision before it was overturned.

While CIMA indicated that they would effectively be responsible for monitoring direct competence and capabilities under the licensing laws. They also stressed the importance of investors conducting their own extensive due diligence into fund directors liabilities, potential conflicts and the actual level of oversight and authority in place. Clearly with this decision the Cayman Court of Appeals is echoing CIMA’s sentiment that investors, not the financial regulators or courts, are the ones who will be financial penalized for conducting insufficient upfront and ongoing due diligence on fund governance issues and directors.

Would AIFMD Have Saved the Day?

What about new AIFMD laws would they have helped in this case to prevent a future escape from liability? Unfortunately, a depositary under AIFMD would not necessarily have been held liable for Weavering losses, as depositaries in general do not take on strict liability for assessing the risks of Alternative Investment Managers (“AIFs”). Complicating matters even further would be issues of shared liability in situations where there may be multiple appointed depositaries. This is an example of the reasons investors should be conscious of these potential gaps in liability when designing their due diligence programs to include a review of the role of depositaries.

What About The Other Service Providers Besides Directors?

Due to the fact that directors effectively delegate a majority of their day to day oversight of a fund to both the fund managers themselves and other service providers such as auditors and administrators, there is enough liability to go around.

 A Governance Reversal?   Cayman Appeals Court Weavering Decision Turns Good Governance Bad

Unfortunately, cases like these demonstrate that there is a bit of a game of hot potato that goes on where everyone passes the responsibility for liability from one service provider (i.e. – the directors) to another (i.e. – the auditors or administrators). With each service provider pointing the finger at each other it can be sometimes difficult to assign exact liability and investors are unfortunately often left unable to recoup their losses from service providers.

Conclusion:

Evaluating the governance structures in place at hedge funds is an ongoing challenge. Simply analyzing the role of the directors is not enough. Rather than limit our focus to a single area, as part of Corgentum’s operational due diligence research, we

partner with investors to assist in evaluating the overall governance risk and control frameworks in place throughout the entire fund complex.

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AIFMD’s Annex IV – Are Hedge Fund and Private Equity Fund’s Prepared?

Investors may have heard rumblings lately in the hedge fund and private equity communities about something called Annex IV. If you a US based investor you may not even have come across the term yet or know why it is being discussed. Complicating the matter further is an alphabet soup of regulatory abbreviations surrounding the term. Here is a quick primer on the issue and why it is important for both US and non-US investors to know about this issue.

Is Annex IV the Same As Form PF?

Annex IV is a regulatory filing that is part of the Alternative Investment Fund Managers Directive (“AIFMD”). Under the AIFMD regime, if you are a fund manager looking to market a fund, referred to as an Alternative Investment Fund (“AIF”) in the AIFMD world, in Europe then you most likely need to fill out some variation of Annex IV.

The form must be filed with a so-called Nationally Competent Authority (“NCA”) in each EU country  where marketing is conducted, such as with the Financial Conduct Authority (“FCA”) in the UK.  It is also worth nothing that investors are not alone in confusion surrounding Annex IV. To provide some clarity, the FCA recently published a guide for fund managers for reporting under Annex IV. Further complicating the matters is that the actual process of filing the form out is also still being finalized. In the UK the FCA is anticipated to allow filing electronically via its GABRIEL system beginning this month. Filing may also be completed by completing the European Securities and Markets Authority (“ESMA”) Annex IV reporting template.

EvolutionSm AIFMDs Annex IV    Are Hedge Fund and Private Equity Funds Prepared?

From the perspective of largely US based funds, many have compared Annex IV to the US SEC’s Form PF. Indeed there are many similarities between the two including varying levels of form completions based on asset under management eligibility criteria, sometimes known as Regulatory Assets Under Management (“RAUM”) . Also similar to Form PF there have been reports of fund managers grumbling about how a firm’s use of leverage can distort the RAUM figure and make them seem larger than they actually are. Why do funds care about this? Wouldn’t showing higher asset levels be considered a good thing? Not necessarily from a regulatory perspective as there are more robust filing requirements for larger institutions, referred to in AIFMD speak as Systemically Important Financial Institutions (“SIFIs”).

Another similarity between Annex IV and Form PF are different filing deadlines for different institutions. Some firms have to begin filings this month and eventually all eligible firms have to report by January 31, 2015.

The types of data collected is also somewhat similar including details of :

  • Markets traded by the funds
  • Portfolio diversification including details of large concentrations and top holdings
  • Investment strategies and markets traded

Based on these similarities some managers have sought to take short cuts and simply copy the data from Form PF into Annex IV. This article from COO Connect outlines however, that this should not be done on a wholesale basis and due to issues such as the way data is grouped differently on the forms only approximately 60% of the information overlaps.eurozone 1948284c AIFMDs Annex IV    Are Hedge Fund and Private Equity Funds Prepared?

Also similar to Form PF, once the initial Annex IV filings are complete there are also ongoing filing requirements. Putting the technicalities aside here is general summary of the ongoing filing deadline:

  • Between €100 million and €500 million – annually ongoing filings
  • Between €500 million and €1 billion: semi-annual ongoing filings
  • Over €1 billion – quarterly ongoing filings

Annex IV Operational Due Diligence Considerations

From an operational due diligence perspective some questions investors may want to ask your fund manager relating to Annex IV include:

  • Are your required to fill out Annex IV? If not, why?
  • If yes, what is your plan to handle to the initial Annex IV filings?
  • Have you worked with domestic and European legal counsel or a compliance consultant to assist in completing the Annex IV filings?
  • Have you discussed any increased data collection and reporting requirements necessary to complete the filings with fund trading counterparties and third-party service providers such as  prime brokers and administrators?
  • Have you begun to collect any data, static or otherwise, for the filing so far? If not, when do you plan to start?
  • Have you gone through the exercise of comparing what data from Form PF you may be able to use for Annex IV?
  • What is the plan for ongoing Annex IV filings?
  • How much do you estimate the time and resources spent on the initial Annex IV filing will cost?
  • Are you working with any third-party firms to assist in completing the filings?
  • Will the expenses for initial and ongoing Annex IV filings, sometimes referred to as offsetting, be passed onto investors as a fund expenses or will they be a management company expense? Is this consistent to the way other compliance expenses such as Form PF have been handled?
  • homepage panel AIFMD AIFMDs Annex IV    Are Hedge Fund and Private Equity Funds Prepared?

Annex IV is simply the latest development fund managers operating in a global environment must navigate. With the steady growth of global financial regulation and compliance requirements through efforts such as AIFMD, it increasingly important for investors to take measures during the due diligence process to learn not only how fund managers are meeting these challenges but also whether investors are sharing the bulk of the expenses for fund compliance.

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