Hedge Funds and Transparency: A Right to Reply

By Anthony Travers, Senior Partner, Travers Thorp Alberga, Cayman Islands (01/02/2013)

The one thing that can be said with absolute certainty about the Cayman Islands and the hedge fund industry is that no one reading the Financial Times editorial of 20 January 2013 or the articles of Mr Sam Jones, Financial Times Hedge Fund correspondent, of 17 January 2013, would have the slightest idea of the true nature of the issues which arise or what may or may not be regarded as a legitimate concern in relation to hedge fund operations in the Cayman Islands. 

At the risk of allowing the facts to get in the way of a rattling good headline, the following may assist those wishing to undertake a proper analysis. 

The statistics are correct.  The Cayman Islands, which has a modern and appropriate regulatory regime, is the domicile of some 9,500 mutual and hedge funds with assets under management of some US$2.2 trillion.  The criticism about this state of affairs arising because of a ‘light touch’ regulatory regime remains ill-founded.  The assets under management are as to some 60 per cent placed with US fund managers and 20 per cent with fund managers in the UK and are thereby subject, as may be, to full SEC, CFTC or FSA regulation. (The percentages may be higher in the US: US States with less than one per cent AUM are not collated .) No additional layer of prudential regulation is therefore required by the Cayman Islands Monetary Authority (CIMA), which has full  transparency  available by virtue of IOSCO regulator to regulator disclosure. 

The suggestion that the new proposals by CIMA must increase transparency for an investor in a hedge fund is highly debatable.  The evidently excitable Mr Vincent Vandenbroucke, head of operations of due diligence at Hermes BPK, is quoted as follows: "We have been screaming for more transparency for some time now". But it is hard to know what additional transparency the CIMA proposals could give to an investor in a hedge fund who ought to be capable of reading the mandatory Offering Memorandum on which his investment is based. This since 1993 has required all material information to be disclosed "as would enable an investor to make a fully informed decision". This provision merely codifies preexisting common law and therefore, the law in the Cayman Islands has always required full information to be disclosed in relation to every director of the fund in which the investor invests.  The investor has a choice.  He can accept the information disclosed, he can predicate his investment on further and better information concerning the directors, including the question as to how many boards each director may sit on, or decide not to invest at all.  Nothing in the CIMA proposals has any bearing on that essential dynamic and nor should it.

 The statement in the Financial Times that the plans to increase transparency and corporate governance "will help investors verify that the directors ostensibly representing them have the ability and indeed time to discharge that duty" is the purest nonsense. Those mechanics exist already not only prior to investment but at any time thereafter. If investors have determined to subscribe by taking non-voting shares, legal consequences follow and nothing in the CIMA proposals will alter that standing. But they remain able to vote with their feet.   The following question posed:  "Why anyone would entrust their money to a fund whose directors they know nothing about is a puzzle" is indeed a puzzle but not as much of a puzzle as why an editor of the Financial Times in light of the legal and regulatory framework that exists in the Cayman Islands would seek to apply that question to a Cayman Islands hedge fund.  The fact that some of the most sophisticated investors in the world would have committed US$2.2 trillion on the basis the Financial Times suggests that current Cayman Islands law and regulation is an evident mischaracterisation. 

But it gets worse. "Transparent corporate governance is one thing", trumpets the editorial, "transparency and company accounts is another."  What this assertion is attempting to suggest is also something of a mystery given that the auditing of every regulated Cayman Islands hedge and mutual fund (by recognised auditors) has been mandatory since the introduction of the Mutual Funds law in 1993.  Mr Madoff could not have operated in the Cayman Islands. Investors may take comfort in the facts of the audit process during which governance is necessarily reviewed. Thus we conclude that under current Cayman Islands law and regulation the investor is perfectly aware of the identity of the directors and has available full audited accounts

The traditional Financial Times mischaracterisations about ‘secretive tax havens’ abound, based either on lack of any due diligence whatsoever on the part of Mr Jones or genuine misunderstanding.  The Cayman Islands has full transparency treaties with the United States and the United Kingdom revenue authorities and furthermore, proactive automatic tax reporting with all European Union revenue departments.  References to ‘tax evasion’ are therefore, or should be, off the table.  The Cayman Islands hedge fund, whether operating in the United States or the United Kingdom, is taxed in accordance with the law of the jurisdiction where the profits are made and its assets and trading activity are regulated in accordance with the laws of that jurisdiction.     

That dispenses with the Financial Times' position.  But what then drives the evident excitement of Ms Roisin Cater of Carne, hedge fund director services, who is quoted as saying: "You can't underestimate how big this is".  Or that of her boss, Mr Peter Heaps, who states, apparently critically: "At the moment anywhere in the world, irrespective of knowledge or experience, you can act as a director of a Cayman entity".  Quite right, too.

But evidently, there is more going on here than meets the editorial eye of the Financial Times

The excitement of the small management company firms, like Carne, is palpable.  What they anticipate is the  separate review to be undertaken by CIMA based on an industry wide survey  for which Ernst & Young has been commissioned. This is to ask the question of whether or not there must be published in a central registry a publically available indication of the number of directorships undertaken by any one individual.  Although this information is available to any investor on enquiry of the hedge fund or the director, the practice of providing over many directorships clearly requires review.

As a result, there may well be a break up of those one or two organisations who specialised in this area who may now be regarded as ‘too big to succeed’ with economic spin off benefit to the smaller players.

The excitement generated it seems is based not on an analysis of the Cayman regulatory position but entirely on self-interest and the prospect that with a mandatory limit on directorships the smaller players may well become bigger . It would be impolite, no doubt, to ask  if they were small for a reason.  However it should be said that if the CIMA proposals were directed at over many directorships per person alone they would be well founded. It seems that a degree of sensible self restraint has been absent in the industry.

But to describe the CIMA’s proposal as a major advance overstates the position and ignores  the reality of hedge fund investment.  The hedge fund investor invariably undertakes his core due diligence on the investment manager and assumes that the hedge fund director whose role is, in virtually every case, supervisory only, will be conducted in accordance with appropriate law and regulation.  As far as the Cayman Island is concerned, that is a very safe assumption.  The law which regulates the fiduciary duties of directors of a Cayman Islands company and their duties of care, skill and due diligence is well settled under English common law principles and has been applied appropriately by the Cayman Islands courts.  In fact, it can be said with certainty that the Cayman Island law governing director's duties is one of the more advanced of any jurisdiction. 

In this respect, the CIMA’s proposals overreach; the need to reduce what are sophisticated and well developed rules of law to a simplistic set of guidelines does nothing whatsoever to assist investor protection.  The point was well put by Mr Justice Jones in Weavering in referring to director's duties where he said “the nature and scope of the duty can only be determined by reference to the actual circumstances of the case.”

So the CIMA’s case for extensive codification of director's duties is not made out.  There is reference to the regulatory initiative of others (which may have been necessary in those jurisdictions) and to the pressures bought by the alphabet soup of international regulatory bodies, so called.  Again we see the shibboleth here attributed to the ‘Senior Supervisors Group’ and presented to the ‘Financial Stability Board’ on ‘risk management lessons on the global banking crisis of 2008’ which apparently concluded that “the Global financial crisis highlighted a number of corporate failures and weaknesses, including insufficient board oversight of senior management inadequate risk management and unduly complex or opaque firm organisational structures or activities.”

This statement is relied on by CIMA as the basis for increased regulation to hedge funds notwithstanding the weight of international opinion, including that of Lord Turner of the FSA, to the effect that hedge funds did not contribute to the financial crisis, the weight of opinion that attributes that crisis to ill-considered political initiatives in the United States and ill-founded regulation of them  and the fact that no financial institution failed in the Cayman Islands as a result of the financial crisis.  What CIMA does not do is the one thing it ought to do, which is to identify any failure in the Cayman Islands as justifying extensive regulatory revision.

We would all be pleased for clarification of the Financial Times references to “failures and shady practices”.  We are aware of only three hedge funds having been bought to Court; that of Weavering being the most relevant. That is good authority for the proposition that directors who do nothing whatsoever to discharge their duties, as they may exist in relation to that hedge fund, will be found liable.  How quite any regulatory initiative intends to improve on the legal clarity applied in that decision is the real mystery.