The failure of hedge fund manager Weavering Capital in 2009 has hit the news again with the start of a trial last week brought by the UK Serious Fraud Office’s against its founder Magnus Peterson. On 14 October, Mr. Peterson pleaded not guilty in a London court to all 16 charges of fraud, false accounting and forgery.
The current trial is the latest in a series of legal actions following the collapse of London-based manager Weavering Capital (UK) Ltd in March 2009. The company was the investment manager to a Cayman Islands hedge fund called Weavering Macro Fixed Income Fund Ltd which had reported net assets of around $600 million at the time of its collapse in March 2009.
The collapse has attracted significant interest in the hedge fund industry. In August 2011, the Grand Court of the Cayman Islands ordered the directors of the Macro Fund to pay a fine of $111 million each for neglecting their duties as directors. The Cayman Islands judgment set out the minimum standards of care expected from independent fund directors. In May 2012, the English High Court issued a $450 million judgment against Mr. Peterson, other directors and senior employees of the manager. The latest court case is the result of the SFO re-opening its case against the firm in July 2012, following the High Court judgment earlier in the year.
At the heart of the Macro Fund’s collapse were related party interest rate swap transactions between the fund and a Weavering company in the British Virgin Islands which had the effect of inflating the reported net asset value of the fund. The related party transactions started following the launch of the Macro Fund in August 2003 and continued until early 2009 when the fund was unable to meet investor redemption requests because the true value of the interest rate swaps (despite representing the majority of the net asset value of the fund) was negligible.
The Case Study
This case study shows how, if the Alternative Investment Fund Managers Directive (AIFMD) had been in force at the time, an independent, FCA regulated AIFMD depositary would have reasonably expected to identify the irregularities and been obliged to blow the whistle to the FCA (or at the time, the FSA). The case study solely draws on publicly reported details surrounding the Weavering collapse, including the judgments of the Cayman Islands and English Courts.
The AIFMD was introduced by the European Commission to regulate financial services in response to the global financial crisis. Its aim was to establish a harmonised regulatory framework for monitoring and supervising the perceived risks posed by unregulated alternative investment funds either managed by European managers or marketed in the EU.
Under the AIFMD, European investment managers wishing to market non-EU alternative investment funds to European investors are required to appoint one or more firms to perform a series of depositary duties: the safe keeping of financial instruments; verification of ownership of other assets not held in custody; cash flow monitoring; and a series of oversight duties which includes oversight over the valuation of the fund, and the fund’s compliance with investment restrictions set out in the offering document. The depositary performs an important fiduciary role to the fund and AIFMD requires depositaries to act honestly, fairly, professionally, independently and in the interests of the fund and the investors of the fund.
Based on details reported about the Weavering case, there were a number of clear red flags which a depositary would have picked up and acted upon when discharging its duties. In each case the depositary would have followed an escalation path which is described later in this study.
Investment guideline review
The depositary is required to oversee the fund’s compliance with investment restrictions. The Macro Fund’s offering memorandum contained a number of representations and investment guideline restrictions including that all counterparties to the fund would be ‘major banks’ and no more than 20% of the fund’s gross assets would be invested in the securities of any one issuer or exposed to the creditworthiness of any one counterparty. As early as March 2004, the fund’s exposure to the related party was understood to be 40%, in excess of the 20% threshold. At the time of the collapse, this exposure had increased to over 90%.
According to reports, the administrator of the fund was primarily responsible for determining the net asset value of the fund at the end of each month. It was at the time, and remains today, common practice for administrators not to take any contractual responsibility for monitoring compliance with the investment guidelines and restrictions set out in a fund’s offering document. Until the introduction of the depositary duties for offshore funds, only the board of the fund and the manager itself typically performed a role in overseeing a fund’s compliance with investment restrictions.
In the case of the Macro Fund, the depositary would have detected the breach of the investment guidelines at an early stage since depositaries perform a check of mandate compliance on at least a monthly basis.
Valuation review
The depositary is required to oversee the valuation of the fund. Fund administrators still calculate the net asset value, but the depositary performs a series of checks to satisfy itself that the valuation of the fund (at each valuation point) is not materially misstated. Given the significance of the valuation of the interest rate swaps to the overall net asset value the depositary would have challenged the manager and administrator to justify the valuation.
Existence and verification of ownership of non-custody assets
The interest rate swaps were ‘over the counter’ derivative trades. As such, the depositary is required to verify the fund’s ownership of the derivatives. Whilst the Macro Fund is understood to have entered into a basic form of ISDA (International Swaps and Derivatives Association) Agreement, it did so with an entity which was clearly related to the manager – very unusual in a market where countless reputable, independent banks trade interest rate swaps. The related party relationship would have alerted the depositary to make enquiries of the manager and the fund to understand the reasons for the transactions and the controls that were in place to ensure transactions were carried out on an arm’s-length terms.
It would have been incumbent upon the depositary to enquire into the veracity and substance of the counterparty. These enquiries would have alerted the depositary to the ‘brass plate’ nature of the counterparty and started the process of escalation as outlined below.
Escalation
In each of the instances above, the depositary would have followed an escalation path to raise the matter and ensure it was appropriately addressed. As a FCA authorised depositary, INDOS Financial would typically expect the escalation to follow this path:
1. Raise issue with manager and seek appropriate explanation, agree remedial action, monitor through to resolution.
2. If manager does not take appropriate action, escalate promptly to the board of the fund.
3. If the board of the fund does not take appropriate action, escalate to the regulator (FCA as the regulator of the depositary and its predecessor, the FSA, for Weavering Capital).
In the case of the board of the Macro Fund, the fund had two directors, consisting of the brother and the stepfather of Mr. Peterson. The Cayman Islands court case essentially found that the directors went through the motions as directors, rather than acting independently and protecting the interests of the investors in the fund. It is highly likely therefore that the depositary would have escalated the matter to the regulator.
Conclusion
Whilst there has been a lot of negative industry sentiment with regards to AIFMD, investors, managers, and fund directors are starting to recognise the benefits of the depositary functions now being performed for offshore funds. The additional layer of checks and balances over the fund, particularly in the area of investment mandate compliance and valuation, are being welcomed.
Awareness is also increasing about the potential for conflicts of interest between depositaries that are affiliated to fund administrators and the benefits of complete independence between these two important service providers.
Whilst AIFMD may not have prevented the collapse of Weavering Capital, there is no doubt an independent FCA regulated depositary would have detected the irregularities and taken appropriate action to blow the whistle long before the eventual collapse. The appointment of an independent depositary will serve as a deterrent to others in the future and the industry will be stronger as a result.
This INDOS article was first published by HFM Week and can be read here (subscription required).
About INDOS Financial
INDOS Financial Limited is an independent AIFMD depositary business. INDOS Financial was the first AIFMD depositary to be authorised by the FCA in January 2014 and is the only independent FCA authorised depositary specialising in hedge fund strategies.