Risk Without Reward

Director's liability for valuations? Insurance please....

Hedgeworld reported comments today from a London based insurance broker, Baronsmead, on the subject of director's liability:

"The recent credit crisis in markets has made it even more difficult for administrators to provide fair valuation for some of these instruments," Robert Kelly, managing partner of Baronsmead, said in a statement. "With the explosive growth in the use of OTC derivatives by hedge funds, directors are facing heightened personal risk, since they have overall responsibility for the operation of the fund's asset pricing policy and the values of illiquid portfolios."

At first glance, offshore investors enjoy a far superior corporate governance framework than onshore hedge fund allocators. In the onshore world, things are straightforward - there simply isn't any corporate governance at all. The general partner of a hedge fund is the investment manager, meaning there is no pretense at independent oversight and control.

In the offshore world, there is a board of directors who, as the "governing body" retain ultimate responsibility for the fund's activities. It is notable that hedge fund best practice initiatives from the UK (AIMA, the Hedge Fund Working Group etc.) all defer regularly to the ultimate authority of the Board. The administration industry, in particular, consistently points out that it is the "governing body", not the administrator, who is ultimately "responsible" for pricing.

Unfortunately, who are we kidding.

Virtually all offshore hedge funds have a small board with a representative from the investment manager and one or two employees of corporate secretarial firms, based in locations such as the Cayman Islands.

The "independent" board members are firstly hired and fired by the manager, not investors - hardly the best recipe for vigorous oversight of the manager's activities.

There's also the practical point that some Cayman directors can sit on hundreds and hundreds of hedge fund boards. If you have 200 directorships, you have a maximum of 10 hours a year to spend on each one, or precisely 50 minutes per month. Hardly sufficient time to get stuck into tricky valuation questions.

The valuation issue is even more paradoxical. "Independent" hedge fund directors typically have a legal, not investment background. While the Board may have "overall responsibility for the operation of the fund's asset pricing policy and the values of illiquid portfolios", offshore directors usually don't have a Bloomberg terminal let alone the ability to model complex derivatives or source alternate quotes from Wall Street brokers. The notion that the board can somehow resolve a pricing dispute so serious that the administrator and manager cannot agree is, of course, entirely unrealistic.

Against this background, we're not surprised that board members want more D&O insurance protection. Insurance premiums are - of course - charged to the fund as an expense and hence paid by investors, but we digress!

What are some solutions? On the one hand, it would certainly be interesting to see an effort from large, institutional investors to propose their own slate of directors on certain funds. We have never seen an adversarial directors' election in a hedge fund context, which begs the question as to why this has never taken place. It would also be interesting if it was somehow mandated that a majority of hedge fund directors should be independent: the revised practices imposed on the mutual fund industry after their brush with the regulators would provide a template. We would, ahem, be surprised to see any enthusiastic uptake on this idea, mind you.

On the other hand, perhaps we should just conclude that hedge fund boards add so little value that it is time to drop the pretense of any meaningful corporate governance framework. That is actually a very timely question - we have recently seen a number of new funds which have launched their offshore vehicles as Cayman limited partnerships, not Cayman corporations. This puts offshore investors in the same situation as their onshore peers - and the general partner is the investment manager.

We have heard no particular reaction or complaint from the investor community about these new LP structures despite the absence of a Board, independent or not. Perhaps, then, corporate governance falls into a different category - something hedge fund investors say they would like but are quite happy to invest without.

Unregulated? Why not....

Hedgeweek reported yesterday that Jersey has launched a new "unregulated" category of offshore fund.  The article notes:

"Amid strong competition among jurisdictions across Europe to offer more lightly regulated regimes for alternative funds, Jersey is seeking to set itself apart from the crowd with the launch of a new Unregulated Funds regime that simply requires eligible funds to notify the Jersey Financial Services Commission of their launch, not to seek approval". 

Robert Walker, chair of the Jersey Finance Working Group is quoted saying  'There is a lot of movement right now at the lightly regulated end of the market, and it made no sense to offer an even more lightly regulated vehicle. We decided it was more honest to offer products that are unregulated and openly advertise that fact.'

Underlying Jersey's initiative would seem to be the view that, for "sophisticated" investors, at least, offshore "regulation" is really an unnecessary charade.  For this structure, Jersey is dispensing with any notion that the handful of civil servants who work in each island's monetary authority are in a position to perform any meaningful "vetting" of fund promoters.  Instead, be straight up and make it clear that the jurisdiction is simply selling a company incorporation service.

We will be interested to watch investor reaction to this new product.   On one hand, some view the offshore fund structure as nothing more than an administrative issue: investors want to give their money to a hedge fund manager, and how the manager structures an offshore conduit to access those returns is pretty much irrelevant.

On the other hand, investors own shares in that offshore corporation, not in the management company.  If things go wrong, they are dependent on the bankruptcy and liquidation process of the local jurisdiction and may well have questions as to whether someone should have spotted warning signs earlier in the day.

On one level, we have a lot of admiration for Jersey's initiative - it's very clear and leaves investors in an unambiguous position.  More fundamentally, though, we have to believe there is some value in a more active regulatory framework as part of the overall corporate, regulatory and fiduciary structure which protects investors' interest.  Cayman remains by far the dominant jurisdiction and some Caymanian initiatives, notably the electronic reporting requirements recently introduced for hedge funds, add evident value.  We would much prefer to see these initiatives extended rather than jurisdictions compete on the basis of the lowest common denominator.

For a hedge fund manager, the million dollar question (literally!) will come when facing investors: do they really want to say that they selected the jurisdiction for their next hedge fund because it involved absolutely no regulation?

10 commandments...what's old is new again

It seems that we are not the only commentator making the point that the Bear Stearns Chapter 15 bankruptcy ruling could refocus attention on the decade old "ten commandments".

Roger Hanson and Ronan Guilfoyle of dms Management Ltd are reported in today's Opalesque newsletter as making the same point. dms is a Cayman corporate services firm providing nominee directors to offshore hedge funds.

Hanson and Guilfoyle have five immediate recommendations:

- "Ensuring that the full board of directors are located outside of the United States and that they hold regular board meetings, indicating that mind and management are not located in the United States;

- Maintaining an offshore operational bank account, and using this for receipt of subscriptions, payment of redemptions and payment of expenses;

- Accepting subscriptions and maintaining the share registration services outside the United States;

- Establishing the investment manager as an offshore entity, who oversees or approves the actions of the U.S. based investment advisor;

- The fund establishing a physical presence in an offshore location from where an employee or delegate of the fund performs functions, particularly those of an investor relationship nature, expense approval, and other tasks currently performed in the United States by the investment manager."

From our perspective, if the Center of Main Interests ("COMI"), the key issue in the Bear Stearns case, is to be outside the United States, we would add to this list that it hardly seems helpful for the offshore hedge fund's official accounting books and records to be maintained by an administrator based in the U.S.

We see some further potential implications from this case:

- We welcome more attention to the location, composition and degree of activity of the Board of Directors of offshore funds, as part of investor focus on the broader issue of corporate governance. Corporate governance is hardly the industry's strong suit, with too many hedge fund boards focused only on local corporate secretarial issues with no meaningful substance. These trends provide an opportunity for more thoughtful and experienced boards to emerge in the offshore world.

- It would be very difficult for an offshore hedge fund run by a US manager who is self administered to be considered to have its COMI outside the US. (Self administration takes place when the manager chooses to calculate the NAV and maintain all accounting records in house with no independent oversight.) Ironically, many of the world's 25 largest hedge fund firms based in the US are self administered, raising this issue in the context of some of the most well known managers in the industry. Virtually no hedge funds - of any size - run by managers based outside the US do not have administrator oversight.

- COMI would surely be enhanced if the official books and records - the monthly accounting which supports each NAV - were maintained outside the US. Hanson and Guilfoyle correctly note that shortly after the repeal of the ten commandments, administration companies rushed to set up offices within the US. Onshore servicing has now become the norm, rather than the exception. The arguments behind this change were both to be closer to clients and to draw on a larger pool of labor than the limited resources in Cayman, Bermuda and other offshore centers. We agree with the first point but are not sure if the experience of the administration industry over the past 10 years supports the second: while there are more accountants in the US, good ones will always work for hedge funds rather than administration companies. Staff turnover in US administration firms seems no better than the revolving door managers used to complain of in the offshore market.

This would seem a great opportunity for administrators to grow offices outside the US in locations which do not have labor constraints. Dublin is close to capacity but Toronto, for example, could benefit greatly from these trends. COMI is much more likely to be outside the US if the administrator is closer to Bay Street than Wall Street.

Return of the 10 commandments?

It is now almost exactly a decade since the "10 commandments" were repealed.  These provisions required a hedge fund managed by a U.S. based firm to perform 10 duties outside the US if they were not to be subject to certain U.S. taxes on U.S. source income.  For history's sake, we repeat the list of those 10 items at the bottom of this post.

The recent United States Bankruptcy Court for the Southern District of New York decision in the Bear Stearns case could well change the rules once more.

In that example, the Court found that Bear Stearns' Cayman domiciled hedge funds were not eligible for protection under Chapter 15 of the U.S. bankruptcy code as neither their "main" or "non-main" liquidation proceedings were considered to be in the Cayman Islands.  The reasoning was that the funds' manager and assets were in New York, while the accounting books and records were maintained by a fund administration company in Boston and, finally, the funds' share registers were maintained by the administrator's affiliate in Dublin.  The only link to Cayman was the initial place of incorporation.

The judge did, however, draw a parallel with another bankruptcy proceeding, Amerindo Internet Growth Fund (actually a hedge fund under liquidation following allegations of fraud).  In that case, Amerindo's investment manager and administrator were in Cayman and both maintained the accounting records and managed the fund's day to day affairs from Cayman.

This raises a new point - to get Chapter 15 relief, does the manager have to be in Cayman (or at least demonstrate more substantial nexus on the island), or is it enough to maintain the principal accounting books and records in Cayman? 

Clearly, the model of offshore hedge funds having accounting performed by an administrator outside the Cayman Islands, and particularly having the administrator in the US, has just been categorised as a very "bad fact" under US law.  As such, I wonder if we will see at least some funds roll back the clock 10 years - will Cayman administrators now be asked to keep the official financial records of the fund?  That's a little more work than only filing the certificate of incorporation.

The ten commandments were:

1. Communicating with shareholders;
2. Communicating with the general public;
3. Soliciting sales of the company's stock;
4. Accepting subscriptions of new shareholders;
5. Maintaining the principal corporate records and books;
6. Auditing the company's accounts;
7. Disbursing payments of dividends, legal fees, accounting fees and directors' fees;
8. Publishing or furnishing the offering and redemption price of the company's shares;
9. Conducting shareholders' and directors' meetings;
10. Making redemptions of the company's stock.