From Macfarlanes

Governance of Cayman Islands regulated mutual funds has received a great deal of focus recently from all corners, including the Cayman Islands Monetary Authority (CIMA), the Cayman Islands Courts and the market at large, particularly institutional investors.

This note considers, in a practical way, how new regulatory guidance may have relevance to the fund’s prime brokerage facilities and how Macfarlanes can assist in that context.

It should be noted that the size, nature and complexity of a fund may be factors in the determination of the adequacy and suitability of its governance framework, so it may not be a case of one-size-fits-all.

LAW AND MARKET GUIDANCE FOR REGULATED MUTUAL FUNDS

1.         Performance of services: There is a need to be satisfied, on a continuing basis, that the hedge fund’s professional service providers are performing their functions in accordance with the terms of their respective contracts.

2.         Contractual terms: There is a need to be satisfied that the terms of the service providers’ contracts are reasonable  and consistent with industry standards.

3.         Scope of services: There is a need to enquire as to the nature and scope of the work which each of the professional service providers is proposing to do or proposing not to do.

4.         Verification  exercise: Every offering document should be subjected  to a verification exercise, the purpose of which is to establish that it is both accurate  and complete.

5.         Compliance monitoring: It is expected  that a hedge fund’s governing body satisfy itself that the fund’s service providers are monitoring compliance with applicable laws and regulations.

Information and  reporting: It is expected  that a hedge fund’s governing body request from the fund’s service providers regular information and regular reporting to enable the governing body to satisfy itself that the hedge fund is operating in compliance with the applicable laws and regulations, and to enable the governing body to adequately oversee and supervise the fund.

7.         Board  meetings: It is expected  that a hedge fund’s governing body shall, where necessary, request the presence of the hedge fund’s service providers at the governing body meetings.

8.         Notification of change in service provider: It is expected  that investors and CIMA should be notified of changes to service providers.

9.         Suitability  and  capability: It is expected  that the fund operator regularly assess the suitability and capability of each service provider.

10.     Compliance with constitutional and  offering documents: It is expected  that the fund operator regularly verify or seek confirmation from the service providers that they are acting in accordance with the fund’s constitutional and offering documents.1

IS A PRIME BROKER A “SERVICE PROVIDER” FOR THESE PURPOSES?

It is not clear from the Weavering decision or the CIMA Guidance whether a prime broker is regarded  for these purposes  as a professional service provider. In Weavering the judge was required to consider managerial and administrative functions delegated to service providers: “The Cayman Islands investment fund industry works on the basis that investment management,  administration and accounting functions will be delegated to professional service providers… [Independent non-executive directors] 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.

Although prime brokers do not appear to be explicitly contemplated, in our opinion (which is supported by Walkers, a leading Cayman Islands law firm), prime brokers ought in principle to fall within the scope of the law and guidance summarised above.

In the Cayman Retail Mutual Funds (Japan) Regulations (2007 Revision), a service provider includes a prime broker. It would be odd if CIMA took this view in one market and not generally.

The various MF forms for use in registering funds in Cayman contemplate  custodians  as service providers. Whilst not all custodians  are prime brokers, all prime brokers are custodians.  Additionally, it is common practice to disclose the prime broker as a service provider in the MF forms.

In the ICP Strategic case12, Justice  Jones  (the judge in Weavering) construed the expression “professional service provider” in the context of specific legislation, but took the opportunity to observe, obiter, that “In its ordinary business  usage, this expression [“professional service provider”] has a very wide meaning.”

Weavering concerned  investment management, administration and accounting functions but there is no indication in the judgment that that represented an exhaustive list of possible service providers. Indeed the judge referred to “the promoter/investment manager, its

Prime brokers provide a bundle of facilities including trade clearance  and settlement, short and long-side financing, custody, position reporting, rolling currency hedging and trading lines. As a matter of business common sense, at least some of these  functions are considered “services”, such as settlement, custody and reporting, in contrast to, say, where the prime broker acts as a trading counterparty.

The courts appear to have also recently acknowledged the service role of prime brokers. In the context of the Lehman Brothers prime brokerage business, Lord Justice  Patten, sitting in the English Court of Appeal, recently observed: “Hedge funds do not have substantial back office functions of their own. They therefore require a third party to deal with the trades themselves and thereafter  to provide custodial and reporting services.”14

Looking to the wider market as a gauge, the Irish Stock Exchange’s “Code of Listing Requirements and Procedures for Investment Funds” appears  to treat prime brokers as service providers.

SELECTED PRACTICAL ACTION POINTS TO CONSIDER

Consider with Cayman counsel whether you and the fund are caught by the CIMA Guidance and/or  subject to equivalent Cayman law (including common law), and how to interpret the expected  standards and/or  law.