Amateur Hour Cancelled

| 30/08/2011

It was bound to happen. There are over 10,000 directors serving Cayman Islands funds – everyone from rank amateurs to serious professional firms – and fund governance has been one of the fastest growing sectors within the hedge fund industry.

Questions had been raised in the press by some institutional investors about the performance of some independent directors during the recent financial crisis and now many of these questions have been decisively answered by the Grand Court of the Cayman Islands Financial Services Division (the “Court”), in its August 26th, 2011 judgment against the independent directors of the Weavering Macro Fixed Income Fund (the “Fund”).

Substantial case law on directors’ duties and responsibilities to trading companies already exists, but this is the first time that the Court has dealt with a case specifically involving directors’ duties to a hedge fund.   In a sound, well reasoned decision, the Court found the independent directors guilty of willful neglect or default in their duties to the Fund and ordered them to pay US$111 million in damages.

This blockbuster award should send a strong message to all recalcitrant directors to either perform their duties and responsibilities properly, or pay a heavy price. 

Now this judgment may not end the discussion about whether amateur or professional fund governance is more effective – Luddite beliefs that are deeply ideological – but the Court did repeatedly confirm its view that independent directors should perform a “high level supervisory role” in a “professional, businesslike manner”.   Fair minded people can form their own judgments about what “professional” and “businesslike” mean when they see it.

To illustrate, the guilty directors fit the amateur model completely – retired and working from home; numerous years of investment management experience with reputable institutions and no other directorships.  The Court found they “had appropriate professional credentials and met the ISE's (Irish Stock Exchange’s) independence requirement.”  

For proponents of the amateur model, they could not have been more perfect examples – yet investors suffer devastating losses at their hands.  It is highly doubtful that this catastrophe could have occurred in a professional fund governance firm, with professional full-time directors having vast fund directorship experience, ably assisted by professionally qualified staff following established policies and procedures based on industry best practices.

The Court decision reaffirmed what astute fund investors and sponsors already know – the professional fund governance model does far more work and is far more productive than the amateur model.  I’ve operated both models and can tell you unequivocally that the professional model is far more effective. 

The Court made some meaningful observations in key areas that are instructive to the fund industry:

Board meetings

Some hold that that the number of board meetings is the litmus test for director performance; however, it is not uncommon for some directors to hold frequent meetings to go “through the motions” believing that the more meetings mean the better (especially if the meetings are being held in attractive locales) and that their obligations begin and end in the boardroom.  This spectacle is pure form over substance.  Amateurs love this approach and scoff at the SEC’s recommendation to hire staff with the appropriate skills to assist them in discharging their duties.  Perhaps now they will heed the SEC’s advice and better understand the value of having professional staff and why they can’t simply attend a few meetings, pick up their check and hit the golf course.  

The Court exposed this charade and did not accept that the regular quarterly board meetings could be “relied uponas the single most important way in which they claim to have discharged their functions”.

Purely focusing on board meetings misses the big picture, as the Court found, as they maybe held merely to “create the impression that the Directors were reviewing the affairs of the company on a regular quarterly basis”.

Duties and responsibilities

In confirming that director duties go beyond the board meeting, the Court held that directors have “a continuing duty to acquire and maintain a sufficient knowledge and understanding of the company's business to enable them properly to discharge their duties as directors.” They need to satisfy themselves, on a continuing basis, that the various professional service providers are performing their functions in accordance with the terms of their respective contracts and that no managerial and/or administrative functions which ought to be performed are being left undone.”  The Court was also critical of the directors in that they never prepared an agenda for the board meetings, never asked any of the service providers to participate in board meetings and never inquired of the service providers – yet another example of where the professional model excels.   It is difficult to imagine any directors meeting the Court’s expectations without employing a team of professionals with a broad range of deep hedge fund skills to assist the director in reviewing complex matters, researching issues and asking probing questions.

Fund operations

Fundamentally a hedge fund is different from a trading company in that it operates through delegates and not employees.  The Court repeatedly recognized the ability, indeed the necessity, for directors to delegate to competent service providers within the hedge fund structure, but also made very clear that such delegation does not absolve the directors of the duty to supervise such delegation, albeit at a “high level”.  Importantly, the Court confirmed that the “directors were not expected to supervise [the "Fund"] trading activities”, making clear that a director is neither a shadow or pseudo investment manager as some have promoted themselves.

Indemnification

Although, these directors were indemnified in the typical manner under the Articles of Association, such indemnification did not protect their egregious conduct.   Effectively the Court’s decision proves the speculation that indemnification leads to directors behaving with impunity to be patently false. Indemnification is intended to protect conscientious, well meaning directors from frivolous actions and the Court will not tolerate any misuse of indemnification provisions.

Crisis management

Historically independent directors responded to a crisis by resigning and distancing themselves from a fund.  During the recent financial crisis, questions arose whether directors acted too precipitously in imposing gates or acted too slowly in liquidating positions.  Reasonableminds can debate these issues, but these directors found a way to do even worse – they did nothing.  Despite not having any other directorships, these directors did not perform effectively.  Directors prove their worth in a crisis and the 2008 financial crisis was the true stress test of a director’s capacity to perform effectively.   The Court agrees “the way in which these Directors behaved during this most serious financial crisis is, in my judgment, the most compelling evidence that they never intended to perform their duties as directors.”

Recordkeeping

The Court found that the directors were “not able to explain why he signed these agreements or how he thought that the arrangement could benefit the … Fund.”  They were also not able to demonstrate the basis for approving certain side letters observing that “there is no evidence that the Directors made any enquiry or sought to understand whether or not the execution of side letter agreements of this sort could impact adversely on the macro fund.”  The Court further observed that “whilst it is common practice for Cayman Islands funds to enter into side letters of this sort, it seems to me that independent directors need to be alive to the issues which are likely to arise.”

While the case did not turn on this issue, the industry should find the Court’s emphasis on documentation noteworthy.

Overall, this is an excellent decision for fund investors and continued confidence in the Cayman Islands fund and alternative investment industry.  It proves that the system works effectively and should blunt any criticism by those proposing extreme concepts and agitating for radical overhaul.   Simply put, the Cayman Islands will hold directors accountable for their poor performance.

Don Seymour is the founder and a Managing Director of dms Management Ltd.

Category: Viewpoint

Comments (20)

Trackback URL | Comments RSS Feed

  1. Anonymous says:

    We can only assume that copies of Seymour’s “Medical” response have been circulated around London, and that printed copies are posted at all of the “water towers” in the offices of the Financial Times.

  2. Just Commentin' says:

    Speaking of directors and "amateur hour": has anyone perused the list of directors of Cayman Airways? Just wondering.

  3. Anonymous says:

    These directors were not independent.  Mr Seymour goes to great length over this judgement being against so called independent directors – the two people concerned here could not really be described as such.  One was the younger brother of the investment manager and the other their ageing stepfather!  Investors who placed money in this vehicle are fortunate for the Cayman courts looking to protect them against their own due diligence failings.

  4. Anonymous says:

    I often wonder when I go to the doctor or hospital whether they take on patients/clients beyond their capacity and therefore can not provide the proper, detailed and careful care they should by reviewing extensively my medical history as well as that of my family and actually provide a treatment that is aimed to fix the cause of the illness and not just the sypmtoms. How big is the risk that something may slip because they never read the full reports?

    I also wonder if the teacher/studen ratios from Kindergarten all the way through University is still appropriate in this day and age and whether the students actually get the proper care, attention and teaching they pay for and deserve.

    I had to wonder if the contractor who built my house which is to keep me and my family save actually knew what he was doing and did have my best interest at heart, or if I was just a number in his books and he was just out to maximize his profits, cutting corners and doing things as cheaply as possible. 

     Look around – the issue of taking on things beyond capacity and therefore lacking proper care and controls are all around – it is not just existing in the financial world and the provision of directorships. It doesn't mean that this is acceptable, but it is everywhere so don't get on a high horse when it comes to taking on directorships. It is all about maximizing profits – and that is wrong in general, not just in the financial world.

  5. DS ME says:

    Don, sincerest thanks for showing us the way.YOU are indeed an oasis of lighted litmus lanterns burning thru the night where the furtive shadows of unprofessional, independent Directors frivolously walk the golf courses that are strewn with checks for services they have never rendered. I don't know how you do it, with all those thousands of quarterly board meetings you have to attend.    

     

  6. Jumbles says:

    At a minimum Cayman needs effective director disqualification procedures.

    • Anonymous says:

      Yes, just as much as they need legislation that not every Tom, Dick and Harry can be a "contractor" and build a family home based on a family's live savings just to find out that he indeed had no qualifications or experience to ever call himself a contractor.

  7. Anonymous says:

    Interesting that the vice-president of the Cayman Islands Directors Association should so stridently take a view which would surely stand in stark contrast to what would under the above available categories (there only appears to be the rather arbitrary "amateur" or "professional" categories the black hats or the white hats – if only the rest of the world were this simple it would make director decisions so easy) be considered the "amateur" albeit personalised and effective approach of many CIDA members, perhaps he will also rally round for a good 'ol witch burnin', it has been years since I have seen a real honest to goodness, frothing at the mouth mob. That said I would not want to be at the next CIDA dinner.

    I am not sure however that the best answer to poor corporate governance is the rounding up of independent directors, like the wild mustangs this article appears to suggest they are, and corral them into a "professional fund governance type" for a commoditised service of neatly priced packages of best dressed meat, a format that over the years has seemed to attempt to argue that, with the support of document delivery elves and possibly the odd conveyor belt, their fiduciary cyborgs can take myriad appointments that a mere mortal adhering to the normal restrictions of time-space (even allowing for the odd theorised singularity) could not supervise if each were to a long only T-Bill strategy, with Nostradamus as Investment Manager, Santa Claus providing the audit function and, for a separation of duties, the administration carried out by the Goblins from Gringotts.

    I also agree with the earlier commentator, and for the sake of the island's company/financial services reputation that foreign lands seem hell bent on destroying, that the "professional fund governance type" and indeed all directors should disclose the number of directorships they hold but only after ensuring that they are sitting on a reasonable number (and you in the front/back no whining about how 200 appointments are not really 200 appointments because there is a master/feeder structure thrown in hither and thither). It would be great if the members of CIDA and the companies they represent could lead the disclosure charge for all amateur and professional "type"s (and any other mythical categories in between).

    p.s. The above aside I do like the use of the word "Luddite", you just don't see that used enough these days…Luddite.

    Disclaimer : This posting is a work of fiction. Any references to historical events, real people, real associations, real articles or real locales are used fictitiously. Other names characters, places, and incidents are the product of the author's imagination and any resemblance to actual events or associations or persons, living or dead, is entirely coincidental. The views hereabove are not my own.

    • Dan Hooray says:

      Look at the board of CIDA and spot those that have been directors of companies that have been wound up by the Grand Court. One of them was even the president and owner of a financial institution.The CIDA is merely a friendly society to safeguard members interests of those involved in hedge funds. What is required here is an Institute of Directors similarly to that in the UK which amongst other things holds seminars for it’s members and potential members on education and current topics of interest. You cannot join the CIDA unles you know two members or are approved by CIMA. That does not help Caymanian directors in the retail or wholesale business to understand their responsibilities and duties. This is sorely needed.
      The CIDA need look at themselves and refocus their direction.

    • Anonymous says:

      Oh dear. The more ponderous the humor, the less amusing one becomes.

    • Chris Johnson says:

      The article by Mr Seymour is not only self serving but misses out many salient points that relate to the provision of directors to companies as a whole. Remember hedge funds represent probably no more than 15% of companies registered in the Cayman Islands. He forgets to mention not only lawsuits taken out in Cayman against directors of non-hedge funds but he also conveniently overlooks the cases brought in the US cases that make direct reference to the unsatisfactory conduct of directors of Cayman hedge funds. One need go no further than look at the pleadings with regard to Beacon Hill Master Fund where the directors were criticized by the presiding judge. Cases in the US courts seldom have the same coverage as those in the Cayman courts and thus the public does not hear about them in the local pres. There of course have been many and in several of them Cayman does come out of it well.

      The provision of directors is an industry and as such should be regulated, not only in the financial sector but in other areas. Laws on directors' disquailification are long overdue and the provision of indemnities under Articles of Association should be banned as they are in other offshore financial centres. Liquidators of insolvent companies run by cowboy directors must have legal remedies to recover monies for creditors, from these masterminds who seem to be bullet proof.It cannot be morally right for liquidators to sue third parties such as auditors leaving directors who ran the ship anyway, to walk away as if nothing took place.

      I should further add that many of these local 'professional directors' were directors of various Madoff Feeder Funds which they have conveniently forgotten about. As I once said there were more red flags to be found on these funds than those at the annual meeting of matadors on Madrid.

      • Anonymous says:

        …and even with specific tip-offs the SEC, one of the most powerful regulatory bodies in the world with a budget exceeding US$900 million annually, missed Madoff.

        • Chris Johnson says:

          The SEC missed Madoff and CIMA missed First Cayman Bank albeit the auditors tipped CIMA off but there again the SEC was tipped off on Madoff. Remind me did someone not say the Cohen deal did not pass the sniff test.

  8. Anonymous says:

    The flipside of the argument, one that Mr. Seymour conveniently fails to mention, is how can "serious professional firms" effectively provide a “high level supervisory role” when they have literally THOUSANDS of Directorships?

     

  9. Anonymous says:

    A most self serving viewpoint if ever i've read one. The author appears to withhold his views on the practice of certain directors of the "professional fund governance type" in years gone by of simply resigining from the Board when the proverbial you know what hits the fan. This could explain why some in the funds industry are so hesitant to make the identity of directors of funds public. The case is a good illustration of what Directors of Cayman funds really are- lackeys of the investment manager. 

    • Anonymous says:

      This is reproduced from a promotional article which generally are self-serving. It is quite funny actually – "don't look at us, its those guys over there!".

      You mean claiming to have resigned from the Board with a backdated letter of resignation which somehow was never actually reflected on the Register of Directors. LOL.     

    • Just Askin' says:

      Are you telling me you actually read the whole spiel?

    • Cicero says:

      Very self serving indeed. Wonder who wrote the article.Pity tbe writer did not take extracts from judges quotations in the US concerning the conduct of Cayman directors. Check them out for yourself and start with Beacon Hill. No prizes as to who the directors were but it does explain a lot.