Cayman's Fund governance: reigning the board of directors

Following similar steps by other jurisdictions  the Cayman Islands Monetary Authority ("CIMA") intend to update its corporate governance guidance  The regulator has posted a consultation paper on its website and has appointed Ernst&Young to perform an industry survey on the topic.

Beyond the reshuffle of its broad corporate governance principles, to align them with international standards, the CIMA is again questioning the right approach to directors supervision. The regulator is considering several improvements to govern the directors' population:

• Require all the individuals providing directorship services to Cayman's regulated entities to register with the CIMA
• Require individuals acting as directors on more than 6 regulated entities to seek approval from the regulator
• In order to improve transparency, the CIMA intend to develop a public database providing limited information on the directors of Cayman's regulated entities. 

Through the industry survey, the CIMA wants to evaluate the pertinence of other measures pertaining to the total number of directorship held by a director. The regulator is considering to require the total number of directorship to be disclosed in the fund's constituting documents and even to impose a limit on this number.

Those steps are clearly aimed at better controlling two categories of directors: the professional directors who sit on a large number of boards and the "blank check" directors who do not provide any oversight and just collect their coupon.

Comparing the current and proposed "Standards of Corporate Governance", the following changes are interesting:

• the requirement for directors to request regular information from their funds' service providers
• the new text emphasizes the need for a documented distribution of responsibilities between the various stakeholders and and appropriate oversight of those delegated functions
• the new standards require the setup of a compliance committee and other sub-committees as needed

Those changes will require from the directors a proactive stance in  seeking information from the service providers and the setup of an appropriate oversight framework of the delegated functions.

The proposed guidance is bringing the Cayman Islands closer to the standards used in European UCIT funds. Several improvements specific to the fund industry could be incorporated in the updated standards like:

• a majority of independent directors
• quarterly board meetings with at least one meeting per year with physical attendance by the directors
• increased transparency through the proposed public database (i.e, name of the service providers, last audit date)

Operational staff challenged by investors' expectations

In order to raise assets for your hedge fund, it is no longer enough to involve the portfolio manager and a client rep. Every employee of the firm need to work at meeting the investors' expectations.

The good news for investors is that, according to a poll recently released by SEI, it appears that CFOs are aware of this new obligation.

According to the poll, conducted recently at the company’s annual Hedge Fund CFO Forum, addressing new regulatory requirements and meeting evolving investor expectations are the biggest challenges for 2011.

Read the press release from SEI here.

Mickey in Insider Trading Land or How the good regulators can help the poor investors

The regulators are not only enacting new laws but they are also looking for way to better enforce existing ones.


The New York Times published an article at the end of May about possible new steps in the U.S. government fight against Wall Street uses of non public information to trade.

From an investor due diligence stand point, identifying insider trading is certainly an issue for several reasons. First, you need to have transparency into the fund’s portfolio at the position level, something that is usually possible only with several months lag. Once you get the portfolio from a trusted and independent source you need to analyze the positions the transactions in order to identify an unusual move or gain. In the case, you are able to spot a questionable investment you are not done because the investment manager may have had a good theory behind buying or selling the specific investment. At the end of the day, you spent a lot of time negotiating access to the portfolio, analyzing the data, questioning the investment manager on probable misconduct and finally you will usually end up with a very weak case to prove insider trading and the investment manager will be angry at you.

Investors need to make their best effort to identify misconduct as part of their due diligence but they also have to be conscious of their limits. If the regulators are able to give a hand in identifying insider trading practices it will certainly be welcomed by investors.

The Next Step in Catching Insider Trading?


The arrest of an assistant to a Walt Disney Company executive and her companion on insider trading charges reflects what seems to be a common perception about the ethics of these investors – even if most ply their trade legally…

Click here to read the article.

Money protection rules: A false sense of confidence

The announcement yesterday by the FSA of its fine against J P Morgan Securities Ltd. has sent a strong signal to UK's financial institutions authorized to hold client money and assets.

The FSA rule seems to provide good protection for clients but this is without considering the option available in the law to opt-out from the client money rules. Amongst hedge funds, it is not uncommon for managers to choose this option since they usually get a better interest income for their cash.

At the end of the day, it is very good for regulator to enforce the rules but it also gives a false sense of protection to investors who don't always understand all the subtleties of the law.

Conclusion: Don't take money protection for granted. Ask you manager the right questions!!


The Financial Services Authority (FSA) has fined J P Morgan Securities Ltd (JPMSL) £33.32 million for failing to protect client money by segregating it appropriately.
Under the FSA's client money rules, firms are required to keep client money separate from the firm's money in segregated accounts with trust status. This helps to protect client money in the event of the firm's insolvency….
Click here to read the FSA's announcement.

Will the new regulations make hedge fund investing safer?

In the last edition of our Due Diligence Bulletin, we cover the recent regulatory developments on both sides of the Atlantic. The main challenge of those new rules will be to avoid regulatory arbitrage. The real benefit of a new regulations are usually visible only after several years, however the investment managers will have to bear the extra compliance costs upfront. Investors should  be conscious that no matter the regulations that will be enacted the only real protection is a proper due diligence before investing.

Read the latest HFDD Bulltetin here.

Hedge Funds exempted from the new SEC Custody Rule

The Securities and Exchange Commission (SEC) has issued amendments to Rule 206(4)-2, the custody rule under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), and related amendments to Form ADV Part 1 and Rule 204-2 on recordkeeping.

The purpose of the custody rule amendments is to impose additional controls on registered advisers that have access to client funds or securities. The primary tool for this is independent verification of the assets. The form of such verification varies depending on the nature of the adviser’s access to or control over the assets.

The custody rule will now require an adviser with custody:
• to undergo an annual surprise examination by an independent public accountant registered with the Public Accounting Oversight Board (PCAOB) to verify client assets;
• to have a reasonable belief after due inquiry that any qualified custodian maintaining client assets sends account statements directly to advisory clients; and
• if the adviser or a related person acts as “qualified custodian” of client assets, to obtain or receive from the related person, a report on internal controls relating to the custody of client assets prepared by an independent PCAOB-registered public accountant.
All SEC-registered investment advisers will be required to comply with the enhanced custody rules. The amendments will be effective March 12, 2010, and registered advisers must comply with the new rules as of that date, except in certain cases where other compliance dates are specified.

Unfortunately, every rule has its exemptions and hedge funds will likely be eligible for such exemption.

In fact, an investment adviser to a pooled investment vehicle that is subject to an annual financial statement audit and distributes the audited financial statements (prepared in accordance with U.S. GAAP) to the pool’s investors is deemed to have satisfied the annual surprise examination requirement. The audit must be performed by an independent PCAOB-registered accountant and the financial statements must be distributed to investors within 120 days of the end of the pooled investment vehicle’s fiscal year end (or 180 days for a fund of funds). In addition, if a pooled investment vehicle is liquidated, it must be audited upon liquidation and the audited financial statements distributed to all investors “promptly” after completion of the audit.

The SEC noted that under the amended rule, an adviser to a pooled investment vehicle that satisfies reporting obligations by delivering audited financial statements to investors is not required to have a reasonable belief that the qualified custodian delivers account statements to investors. The SEC has directed its staff to explore ways in which additional protections may be afforded to investors in such vehicles.

For further reading and sources, I recommend the bulletin on the subject published by Katten Muchin Rosenman. You can find the document at the following address:
http://www.kattenlaw.com/sec-adopts-custody-rule-changes/

CFTC moves to curb speculation in the commodity markets

The CFTC has not been long to take actions following the three days hearing held in Washington regarding speculation in the commodity markets. According to the Financial Times:

"A commodity investment unit of Deutsche Bank and another fund group have been stripped of their exemption from speculative limits in key agricultural futures including corn and wheat.
The move by the Commodity Futures Trading Commission reflects the US regulator's growing scepticism towards commodity index investing and its concerns over the role of speculators in raw material markets.
Yesterday's move is the first time the commission has revoked an exemption from position limits, a CFTC spokesman said."

Instead of keeping a low profile, Hedge funds are again in the headlines. Also in today Financial Times, we can read:

"A hedge fund has made a large bet that natural gas prices will triple by the winter just as the price of the commodity slides to a seven-year low.
Traders took notice last week when the fund, as yet undisclosed, spent millions for the right to buy US natural gas at $10 (£6.03) per million British thermal units in January and February, up from today's spot level just above $3 per mBtu."

If the CFTC was looking for good reasons to impose new speculative limits on energy trading here is an easy one.

Dark clouds on CTAs

The U.S. Futures Trading Commission has conducted three days of hearing in Washington, in July and August, to discuss with industry specialists the role played by speculators in the energy markets and the different ways to reduce their influence. Also, the regulator admits that speculators are playing an important role as providers of liquidity, they want to avoid them influencing too much prices of consumer goods of finite supply like oil. Speculators have been blamed for record high commodity prices such as crude oil, which climbed above $147 a barrel in July 2008, and for the crash to near $30 in December. Oil is currently at around $65 a barrel.

The CFTC is weighting the introduction of position limits on the energy markets. At present, the commission imposes position limits in a number of agricultual commodities including corn, oats, wheat, soybeans and cotton. The current limits are described in the following table.

The different commodity exchanges also impose position limits, or accountability limits, on some contracts at their discretion.

Regulators and exchanges recognize the different between market participants using the commodity markets to hedge their business and speculative traders who try to make money out of it. Hedge participants are usually granted exemptions from regulatory or exchange limits. Banks and investment trading houses are routinely granted exemptions from position limits because they execute market hedging for commercial interest, but these banks often have a speculative position as well. The other categories of participants getting exemptions are the swap dealers which conduct transactions over the counter and then buy or sell futures on exchange to reduce their risk. Some large commodity index funds use the swap dealers exemptions to built big positions without having to respect position limits. According to the Wall Street Journal, over $300 billion was invested in index funds in July 2008, up over four-fold from 2006.

The CFTC's view on position limits is not shared by the UK Financial Services Authority. UK regulation requires commodity exchanges such as the London Metal Exchange to operate fair and orderly markets and in order to do so they have rules that enable them to monitor and manage members' positions. There are doubts about whether the FSA should resist the path of position limits to limit speculative influence on commodity prices. Energy consultant John Hall said any action on position limits has to be global. "The FSA will have to reach some kind of compromise as you cannot have vastly different rules operating in different countries".

The implementation of the position limits and the potential new rules on exemption granting will have to be monitored carefully. A possible outcome is that the job of setting position limits will be moved from the exchanges to the CFTC. The CFTC might also look to view position limits on an aggregate basis, meaning contracts done on the exchanges as well as those done over the counter (OTC). The main risk for regulators with the new rules will be the switch by market participants from regulated axchange markets to unregulated OTC markets and dark pools.

Hegde funds, actively trading the different commodities markets, are monitoring carefully the ongoing discussions. The new rules could force them to implement changes in their trading programs to comply with the new limits. The funds that are the much exposed are the large CTA managing over $10bl in assets like Transtrend, Winton, Man AHL ... or the managers specialized in a specific segment of the commodity market. Typically, CTAs are trading a diversified portfolio of commodities with the energy sector representing only a relatively small part of their allocation. However, a change in the funds trading away from the exchange to the OTC market may represents an operational challenge and will certainly increase the risk of trading errors and the risk linked to OTC counterparties vs the safety provided by the exchange trades futures contracts.

According to the CFTC Chairman, Gary Gensler, the CFTC may issue a draft rule this autumn. Once the draft is laid out, it will open for a 60 days public commentperiod before formal rules are put in place.

G20: Regulators priority is systemic risk not investor risk

The different hedge fund industry's stakeholders have been waiting for the G20's new rules announcement with each very different expectations. Hedge Fund managers were hoping for not too much burdensome new rules and ,on the other hand, investors were expecting new measures to protect their assets.

The following extract from the "Declaration on strengthening the financial system" at the G20 summit of April 2nd, 2009 describes the broad lines of the coming "new order":

"hedge funds or their managers will be registered and will be required to disclose appropriate information on an ongoing basis to supervisors or regulators, including on their leverage, necessary for assessment of the systemic risks that they pose individually or collectively. Where appropriate, registration should be subject to a minimum size. They will be subject to oversight to ensure that they have adequate risk management. We ask the FSB to develop mechanisms for cooperation and information sharing between relevant authorities in order to ensure that effective oversight is maintained where a fund is located in a different jurisdiction from the manager. We will, cooperating through the FSB, develop measures that implement these principles by the end of 2009. We call on the FSB to report to the next meeting of our Finance Ministers and Central Bank Governors; "

In regards to the other measures announced, commentators have focused particularly on the "minimum size" condition which may imply that only the largest hedge funds will be concerned by the new rules. The "minimum" mark is yet to be set but the risk of a broad set of new rules concerning all the industry looks now remote. The majority of the fund managers are probably happy with the outcome of the summit while a majority of investors are probably disappointed.

We think that the declaration is providing a message to investors that regulators' priority is to protect market against systemic risk and not to provide an extra direct protection to investors".The group of 20 has realized that they need to set achievable goals to the new regulation. The recent fraud cases in the investment management industry have revealed that regulators already have difficulties in enforcing the current regulation. Furthermore, the extra-burden of further regulatory rules on the small investment managers, who represents a majority of the hedge fund industry, will have pushed a lot of them out of business.

Investors should not expect too much from the "new rules" but according to the number of litigation cases brought by the SEC against investment managers in the US yet this year it seems that the enforcement of the current rules is already a positive step in itself.