On 22 December 2011, the Cayman Islands introduced legislation to widen the range of master funds that are required to register with the Cayman Islands Monetary Authority (“CIMA”). The affected funds that are now required to register are open-ended funds which have a CIMA regulated fund as an investor, where the regulated fund conducts 51% or more of its investing through another fund.

The new legislation does not impact closed-ended funds or funds for a single investor.

Timeline

The amendments to the Cayman Islands Mutual Funds Law came into force on 22 December 2011. Any new affected fund will need to comply with the amended law immediately. Existing funds will have a 90 day grace period (which is subject to possible extension by government regulation).

The change to the earlier law

Under the Mutual Funds Law, unless an exemption applies, funds that are formed (or make a public offer) in the Cayman Islands which offer equity interests redeemable at the option of an investor are required to register with CIMA.

Prior to the amendment of the Mutual Funds Law, an exemption from registration applied to any fund with fifteen or fewer investors where those investors have certain powers of control over the operation of the fund (the “15 Investors Exemption”). The amendment to the law has effectively narrowed the 15 Investors Exemption with the result that many funds that operate as a master fund within a typical “master-feeder” fund structure will now be required to register with CIMA.

Identification of affected master funds

In summary, the Mutual Funds Law defines the affected master funds that are now required to register with CIMA to be funds that:

• are formed in the Cayman Islands;
• offer equity interests redeemable at the option of the investors;
• have one or more “regulated feeder funds” as investors; and
• have (or intend to have) more than one investor.

A “regulated feeder fund” is a fund regulated by CIMA that “conducts more than 51% of its investing through another mutual fund”.

Application to typical structures

In the case of a typical “master-feeder” fund structure, there are two principal outcomes:

• where the feeder fund is registered with CIMA, the master fund will now be required to register with CIMA; and
• where the feeder fund is not registered with CIMA (e.g. in reliance upon the 15 Investors Exemption), then the master fund may rely on the 15 Investors Exemption and thus also avoid registration with CIMA.

It should be noted that under the new provisions:

• there is no requirement that the master fund and feeder fund are under common or affiliated management;
• there is no clarification of when or how the 51% test is applied, for example in the case of a fund with fluctuating allocations or in the case of an umbrella fund;
• the legislation does not expressly link a feeder fund to a single master fund (and accordingly a feeder fund could conceivably “trigger” several investee master funds into a registration requirement); and
• a regulated fund could conceivably be considered a regulated feeder fund if it invests more than 51% of its assets in a foreign mutual fund.

Accordingly, careful analysis will be required for any case of potential doubt.

Registration requirements for affected master funds

Affected master funds will need to register with CIMA. Assuming the minimum investment level for each investor in the fund exceeds US$100,000, the procedure will be similar to most fund registrations, though with some streamlining where there is an overlap with the filings made in respect of the feeder fund. The principal requirements will be:

• payment of the initial and annual fees;
• initial filing of letters of consent from the auditor (who must be a Cayman Islands auditor) and the administrator of the fund;
• initial filing of a copy of the certificate of incorporation or registration for the fund;
• annual filing of locally audited accounts (and related annual review information); and
• initial filing and ongoing maintenance with CIMA of limited registered particulars concerning the master fund and, if one has been prepared, any offering document for the master fund.

An application for registration will not entail a substantive review of the fund’s terms by CIMA, and registration should be automatic upon submission of a completed application. It is envisaged by the legislation that CIMA will not require a master fund to produce a separate offering memorandum.

Registered master funds will be subject to the full provisions of the Mutual Funds Law, including the supervisory powers of CIMA and the whistle blowing obligation upon the fund’s auditors.

The initial and annual fee for a registered master fund is US$3,048 (which is less than the rate of US$3,658 applicable to other kinds of registered fund). Given the slightly reduced fees, we expect master funds that have previously registered under the Mutual Funds Law (for example where the 15 Investors Exemption was not available) may choose to re-register under the new regime.

If an affected master fund cannot observe the minimum investment level of US$100,000 for each investor (for example, due to having existing small investments into the fund), then alternative compliance with the Mutual Funds Law may be required, such as direct substantive licensing from CIMA or by appointing a local administrator that assumes specified supervisory responsibilities.

No impact on closed ended funds, single investor funds or wholly unregistered “master-feeder” fund structures

The following exceptions from registration under the Mutual Funds Law continue to apply:

• closed ended funds (i.e. funds which do not offer investors a right to redeem their interests) are not required to register;
• funds for a single investor are not required to register; and
• “master-feeder” fund structures where both the master fund and the feeder fund rely on the 15 Investors Exemption are not required to register.

Next steps

Operators of Cayman Islands funds should contact their legal advisers to assess the legal and business impact of the amendments to the Mutual Funds Law on them. A number of master funds will now require registration or restructuring with consequent amendment to their offering and constitutional documentation. Operators of unregistered Cayman Islands funds may need to review their investor bases and consider procedures to monitor (and, as necessary, assess powers to exclude) investment by Cayman Islands registered feeder funds.

Both cases involve Cayman investment funds with independent directors on their boards. Those directors are in one case alleged and in the other found to have failed to discharge their duties as directors in broadly similar ways.

The claims turn, to a greater or lesser degree, on a lack of involvement and  supervision with regard to directors’ duties and a disregard, whether couched in terms of negligence or willful default, of proper investigation by the directors into the  inflated value of each fund and a series of unauthorised related party transactions.

There is no new law in these cases and an in-depth analysis of the well-enshrined  common law duties of directors is not attempted here. These cases are about the application of those duties. Some of the underlying issues that were unearthed are important, not only in the Cayman context, but also across the professional spectrum. These are issues of form over substance, conflict of interest and the relevant standards of directors in the performance of their duties.

Ought to-cratic

It is trite law that directors of a company owe duties to the company of which they should be aware. What these cases highlight is the extent to which directors cannot simply rely on the judgement or influence of other  people, such as arrangers or principals.

Weavering makes it clear that directors are not expected to have unlimited  knowledge and expertise across all sectors, and that it is perfectly acceptable that  directors delegate and engage external advisers to assist them, provided the  boundaries of responsibility are defined clearly and the directors do not lose sight of their duty to keep themselves informed and supervise those delegates.

It is common for offshore directors to sit on the boards of numerous companies – often hundreds. This is possible where  companies are largely on autopilot once the mechanics have been put into place, and is more true of structured finance transactions than  mutual and hedge funds simply because more of the financial engineering can be approved in the former case at  inception.

The vast majority of offshore directors have adequate professional qualifications and should be able to assess commercial situations with the right supporting  knowledge obtained from those to whom they delegate. That, though, does not seem to have been true in either Weavering or the Bear Stearns case, with directors signing off  minutes when it is questionable whether they knew what was really happening.

Pay-related performance

There is speculation as to whether the  problem boils down to a question of fees and whether the directors would have acted  differently if their fee levels had been higher. The correlation between fees and level of responsibility assumed by the directors was raised in Weavering, as it was in the famous Jersey trust case of Abdel Rahman v Chase Bank (CI) Trust Company Ltd & Five Ors (1991).

In Weavering the judge rebutted firmly the suggestion that the level of responsibility assumed was diminished because the  directors were not taking a fee for their role and countered that the lack of fees was rather indicative of the fact that the directors never, in fact, intended to perform their duties in any meaningful way.

Is the same true for the Bears Stearns  offshore directors? Would they have  performed better had their fees been  higher? It is difficult to say, but what the Bear Stearns case brings to the fore is that fees and issues of conflict are closely linked.

In Weavering the failure to perform resulted from personal conflict considerations and possibly indifference. The Bear Stearns  situation seems only slightly  different – those funds had apparently independent offshore directors on their boards coupled with an independent trustee holding voting shares, but both service providers were related to the offshore law firm.

It is perhaps inevitable that offshore  service providers for a client such as Bear Stearns with their eye on valuable future instructions will have regard to the fresh carrot both for themselves and their  affiliated law firm, while still gnawing through the first.

The affiliations that have been established over the years between offshore law firms and their management services arms may be detrimental to interested parties, as the Bear Stearns case demonstrates. A truly independent set of directors or fiduciaries would not face the same internal level of conflict or feel the inevitable pressure  associated with being a business conduit to the affiliated law firm. The same position of conflict is evident from the point of view of the affiliated law firm.

Heads up

We must not lose sight of the fact that the demands of principals are often onerous and have militated in favour of the ’one-stop shop’. But in these cases the directors were all asked to perform in short order, often without proper explanation. The cases highlight the fact that the ’head in the sand’ approach will not work. Directors must ask the right questions and gather a meaningful amount of information to which they apply real discretion in order to avoid a sham situation arising.

Unless directors and service providers are able to be truly independent and act without conflict, and until the boundaries of responsibility, expectation and conflict are satisfactorily addressed, the pressure will mount and the types of collapse evidenced by these cases will continue even in highly regulated jurisdictions such as Cayman.

The jury is still out on whether the one-stop shop model best serves the interests of the client and their investors.

This article was first published in The Lawyer on 7 November 2011.