On 5^th August 2020, the Cayman Islands Monetary Authority (CIMA) discontinued and removed its “Equivalent Jurisdiction Regime” (EJR) list from use and application to Cayman Islands domiciled investment entities and funds (Funds).

The EJR list, which had previously contained over 40 separate countries, allowed persons conducting relevant financial business from or within the Cayman Islands to place reliance on AML/CFT legislation of specified countries for simplified customer due diligence. Now removed, the responsibility of determining the anti-money laundering (AML) risk ratings applicable to the countries detailed in the EJR list has moved to the persons conducting the relevant financial business (e.g. Fund Board / Fund Administrator) (FSP).

Following the removal of the EJR list, it is possible that previous regulatory exemptions applied to certain countries may no longer meet the Cayman Islands AML requirement for the application of SDD. The AML regulations and accompanying guidance notes say that in order for SDD to be applied, a person, or applicant for business who is or appears to be acting as an agent or nominee for a principal, must be based or incorporated in or formed under the law of a country which the FSP assesses as having a low degree of risk of money laundering and terrorist financing.

The immediate effects of the list’s removal; and any reliance which has continued to be placed on it by FSP are yet to be determined, however, a review of the internal country AML risk classifications and the application of SDD on investors is warranted to ensure continued compliance with the AML regulations in place.

The Cayman Islands Private Funds Law 2020 (CPFL) is now in full effect and, for the approximately 12,000 private equity, real asset and other private closed-ended funds that met the August 7, 2020 deadline to register with the Cayman Islands Monetary Authority (CIMA), attention will now turn to how best to comply with the ongoing operational requirements.

Many of the CPFL obligations are similar to existing requirements for CIMA-registered open-ended funds and may be familiar to the newly registered closed-ended funds.

Although the Cayman Islands Private Funds Law provides managers flexibility with regard to performing the functions internally or appointing a third party to carry them out, there is much to consider in determining the best approach for the fund. Although some guidance notes have been issued by CIMA, further guidance is expected to be issued in due course.

The key operating conditions that are unique to the CPFL are summarized below.

Considerations in determining the best approach

CIMA is under pressure to show a robust regime

The CPFL is one of several regulatory changes impacting Cayman Islands domiciled funds over the past two years. Like other offshore fund domiciles, the Cayman Islands is under international pressure to demonstrate it has a robust regulatory framework that can withstand scrutiny.  In June, CIMA amended and expanded its Administrative Fines regime reinforcing the need for all operators of Cayman funds to understand and properly comply with their obligations.

In July, we saw last minute changes made to the CPFL to broaden its scope and clarify requirements around the identification and management of conflicts of interest, designed to ensure managers comply with the spirit not just the letter of the law. We expect similar changes will be introduced if funds should merely “check the box” on compliance with the operating conditions.

To create a program that is beyond “check the box” compliance, firms should consider the appointment of independent third parties to carry out these functions where it makes sense to do so. Firms that opt to handle any of the above functions in-house should ensure that the internal program is properly documented and evidenced and subject to regular independent compliance oversight.

There are opportunities to create efficiencies

The above operating conditions are similar to requirements in other regulatory regimes. Funds can create operational efficiencies by taking a holistic view on compliance across multiple jurisdictions. For example, Europe’s Alternative Investment Fund Managers Directive (AIFMD) regime requires similar operational functions, except that the AIFMD takes the extra step of requiring that the functions be carried out by a depositary. By appointing a depositary to comply with the CPFL, non-EU fund managers are only a small step away from complying with the depositary requirements that will enable them to market their funds in countries such as Germany and Denmark without relying on reverse solicitation.

Funds can also create efficiencies by using a service provider that is well versed in other Cayman Islands requirements such as the appointment of an Anti-Money Laundering Compliance Officer and Money Laundering Reporting Officer.

Funds and their managers can save time and money and reduce their risk by turning to independent third parties that have significant experience acting as outsourced AML officers under the Cayman Islands regime as well as experience carrying out the CPFL operating conditions.

Why INDOS

INDOS Financial is an independent fund oversight business for alternative investment funds, including closed-ended private equity, real estate, infrastructure, and debt funds, as well as open-ended hedge funds. With over $35 billion assets under oversight, INDOS has significant experience providing outsourced AML Officers as well as custody, cash flow monitoring and asset verification under the CPFL and AIFMD. INDOS is a trusted independent third party to over 100 Cayman Islands domiciled funds and is ready to help funds ensure compliance with the Cayman Islands Private Funds Law 2020 and AML Regulations.

The thorny issue of fund costs and charges has been hotly contested by EU regulators for a number of years now amid concerns that investors were being disadvantaged. This focus continues and in June 2020 the European Securities and Markets Authority (ESMA) published a supervisory briefing for European national competent authorities looking into the charging structures at UCITS and alternative investment funds (AIFs) regulated under the Alternative Investment Fund Managers Directive (AIFMD).

In essence, its proposals seek to ensure that EU regulators consistently supervise the cost-related provisions in the UCITS and AIFMD legislation in order to prevent undue charges being borne by investors. The proposals could also present an opportunity for independent depositaries acting in the best interests of investors to broaden the scope of their oversight over the operations of funds.

The briefing states that managers of UCITS and AIFs should produce comprehensive “pricing process” reports, outlining and reviewing their individual fund costs. In order to prevent any unfair investor charges, ESMA is recommending that fund managers consider an extensive range of data points in their reports, adding that costs should be clearly disclosed to investors in a comprehensive and transparent manner. As part of this exercise, managers must clearly articulate the following:

• An assessment on whether their costs are necessary for the fund to operate in line with its investment objective
• Evaluate whether their costs are proportionate compared to market standards and the type of service provided, with a particular emphasis on potential conflicts of interest
• Determine if the fee structure is consistent with the characteristics of the fund
• Assess whether the costs borne by the fund are aligned with the net returns
• Ensure that all charges are fair and that investors are treated equally
• Validate that there are no duplicative costs for services
• Verify that any fee caps are applied and clearly disclosed to investors
• Corroboration that UCITS/AIF performance fees comply with ESMA’s guidelines
• Confirmation that all costs are disclosed in line with the applicable EU rules (i.e. UCITS, AIFMD, Packaged Retail Investment and Insurance Linked Products [PRIIPS])
• Ensure that the process and all fees are based on reliable and documented data

ESMA’s consultation broadly mirrors some of the rules which have already been rolled out to authorised retail funds in the UK. In September 2019, the Financial Conduct Authority (FCA) pushed through with its new Value for Money provisions, a set of rules which require UK managers to produce reports for investors periodically demonstrating how they are delivering value, including an assessment of the costs and charges applied to the fund.

The longer-term question of whether these rules will be imposed on the UK funds industry post-Brexit is open to debate. However, UK regulators are widely accepted as being very forthright on the issue of costs and charges. The UK’s Retail Distribution Review clamped down on commissions well ahead of MiFID II (Markets in Financial Instruments Directive II) while the EU authorities are currently playing catch-up on the Value for Money requirements and the Senior Managers & Certification Regime’s (SMCR) accountability provisions. With the UK looking to retain its EU fund distribution footprint after Brexit, it is unlikely that the FCA will want to deviate or diverge from ESMA’s proposals.

As regulators continue to pivot their attention towards fund charges, it is likely that service provider relationships could come under further scrutiny. For instance, the ESMA consultation explicitly references third party costs and conflicts of interest, which will prompt asset managers to analyse whether they are receiving genuine value from their vendors.

In common with incoming changes to the UCITS and AIFMD liquidity risk management rules, which will require depositaries to ensure that managers have adequate liquidity risk management policies and procedures in place, regulators could look to the depositary to perform similar oversight of the pricing report process. Independent depositaries which are not tied to other service providers of the fund, such as the fund administrator, and therefore less conflicted will be in a strong position to monitor the conduct of these cost assessments and enhance investor protection.

Although some asset managers will almost certainly lament the additional workload,  the shift towards improved transparency around charges is a positive development and will address one of the frustrations often expressed by investors about cost transparency.  Enhanced disclosure around charges will enable operational due diligence teams at investors to better benchmark their fund manager costs. The firms which embrace openness and adopt equitable charging structures may well benefit as a result.

The ESMA Supervisory Briefing: https://www.esma.europa.eu/press-news/esma-news/esma-promotes-convergence-in-supervision-costs-in-ucits-and-aifs

Scrutiny of the alternative asset management industry by regulators, investors and fund directors is unlikely to taper off. Conversely, these market participants are taking an increasingly uncompromising line against asset managers and funds who they perceive as being too lightly regulated or without adequate governance and fund oversight.

Fund hubs ramp up their supervision

In the aftermath of the 2008 crisis, regulators – especially those in the European Union (EU) – took it upon themselves to improve standards across the asset management industry. Regulations such as the EU’s Alternative Investment Fund Managers Directive (AIFMD); Irish governance reform in the guise of CP86 and the UK’s Senior Managers and Certification Regime (SMCR) have all helped strengthen governance and accountability across the alternatives ecosystem.

Offshore fund domiciles were slower to adapt until relatively recently. These jurisdictions, however, acknowledge that they also need to reform if they are to retain market share and meet the expectations of institutional investors. Beginning in 2018, the Cayman Islands introduced anti-money laundering (AML) and counter terrorist financing legislation in response to the Caribbean Financial Action Task Force’s (FATF) recommendations on combating money laundering and terrorist financing. These changes are part of a wider regulatory overhaul.

The country’s regulator – the Cayman Islands Monetary Authority (CIMA) – is now pushing ahead with additional investor protection rules. The Private Funds Law 2020, which came into effect in February, requires all existing, closed ended private funds domiciled in the territory to register with CIMA by August 7, 2020. The rules also stipulate that private funds must comply with new custody, cash flow monitoring, asset verification and valuation requirements. Funds are also required to appoint a Cayman Islands registered auditor.

The Private Funds Law states that these duties can be undertaken by the manager themselves on condition they are carried out independently of the investment management process. Furthermore, any conflicts of interest need to be properly identified, managed, monitored and disclosed to investors.

Otherwise, managers can outsource some of these functions to an independent third-party service provider. These sorts of obligations are the norm for many open ended Cayman Islands funds managed by European managers subject to AIFMD, who appoint a depositary to undertake such activities. However, the provisions are new to the Cayman Islands’ closed ended funds industry. This could therefore result in alternative asset managers running closed ended offshore Cayman Islands funds turning to experienced depositaries for assistance.

Onshore markets tighten their oversight procedures

As the Cayman Islands becomes more regulated, a number of Hong Kong and Singaporean managers who have historically used the Caribbean territory as a domicile – are now rethinking their choice of jurisdiction. This has also been accelerated by the development of new fund structures in Singapore (the Variable Capital Company) and Hong Kong (the open ended fund company), both of which borrow heavily from equivalent European fund structures.

Moving forward, it is possible that Hong Kong and Singapore could further strengthen their governance standards and integrate even more of AIFMD/UCITS’ requirements into their local laws, including the mandatory appointment of a depositary. Asian fund buyers have long supported the investor protections available to them under AIFMD/UCITS in particular. By insisting locally domiciled funds appoint a depositary, market regulators in Singapore and Hong Kong could play a material role in driving inflows into their domestic fund structures.

European regulators are also beginning to take a tougher and more proactive line on fund oversight. The CSSF in Luxembourg, for example, recently levied fines against two depositaries for their failure to comply with the rules. Consequentially, it is crucial that alternative asset managers give proper thought when selecting their depositary provider.

Investors and fund directors take aim

Institutional investors have for many years expressed reservations about the calibre and quality of fund governance. Although the hedge fund industry has made notable improvements to its corporate governance, the private equity world has yet to make quite the same progress. This is partly because private equity firms execute fewer transactions than hedge funds as their holdings are illiquid. Nonetheless, a number of investors are now urging private equity firms to improve their corporate governance processes.

Governance practices are also being enhanced as a result of regulations such as SMCR, which subject senior managers at financial institutions – including asset managers – to greater levels of accountability. Anecdotally, there is now growing evidence that fund directors are taking a more active approach to carrying out their fund oversight duties, including more careful examination of risk management processes and performance of service providers. The COVID-19 crisis will certainly reinforce the importance of effective fund oversight and on-going monitoring.

The 2008 financial crisis revealed many corporate governance deficiencies at alternative funds. Twelve years on, Covid-19 is causing a different set of challenges. Bill Prew, CEO of independent depositary INDOS Financial, assesses whether governance practices in the industry have improved and if investors’ interests are now being better safeguarded. 

The 2008 financial crisis exposed many deficiencies in corporate governance practices in the alternative funds industry. Not only was it revealed that a lot of offshore boards failed to prevent managers from succumbing to style drift and investment mandate breaches, but when the crisis hit, many directors simply permitted firms arbitrarily to impose gates and suspend redemptions without proper consideration being given to the best interests of investors. Many were left trapped in funds for long periods as a result.

As markets stabilised, investors made it clear that some directors had neglected their fiduciary responsibilities and promptly demanded reform. Twelve years on from the financial crisis, Covid-19 is causing a different set of challenges.

Driving up standards

Since the financial crisis, fund governance has largely improved, in part because of the pressure exerted by investors. In the years after the crisis, investors started clamping down on managers appointing so-called “jumbo” directors who were sitting on a large number of boards. This came amid concerns that some directors were overstretched and would be unable to perform their roles adequately in a crisis scenario.

Elsewhere, investors insisted boards be comprised of more independent directors so as to minimise any potential conflicts. Other clients asked that boards become more diverse in terms of skill-sets and expertise, amid concerns that people from the legal and fund administration professions disproportionately dominated directorships.

Regulators have been equally proactive. The Alternative Investment Fund Managers Directive (AIFMD) was introduced in Europe in 2014 and raised standards in areas such as risk management and oversight, including through the introduction of the fund depositary to oversee the operations of funds. A number of depositaries have been praised for providing useful information to fund boards enabling them to fulfil their fiduciary duties.

Local regulators in Europe have taken further measures too. For example, the Central Bank of Ireland (CBI), introduced the CP86 framework, which among other things requires funds to have at least two, independent, Irish-resident directors on their boards. CP86 also stipulates that directors demonstrate they have sufficient capacity to perform their roles adequately.

Similarly, the UK Financial Conduct Authority (FCA) implemented the Senior Managers & Certification Regime (SMCR) as part of its efforts to improve accountability in the financial services industry. This – along with several “Dear CEO” letters – has resulted in managers taking governance more seriously.

However, improvements are not uniform across the alternatives industry. Governance practices in open-ended hedge fund strategies are generally regarded as being stronger than long term closed-ended fund structures, where investors are often content to invest in funds that do not have independent directors acting in their best interests or holding managers to account. Unlike open-ended funds, many closed-ended structures have historically fallen outside regulation. This is particularly true for private equity funds established in the Cayman Islands.

However, this is set to change in August 2020 with the introduction of the Cayman Islands Private Funds Law, which will subject private equity firms to regulatory registration requirements, and depositary provisions largely based on AIFMD.

There are also nuances in corporate governance practices between alternative funds and other fund structures such as UK-listed funds. Some argue that governance in alternative funds is more process driven than in listed funds, where directors are usually required to take a more strategic, hands-on approach.

Governance amid Covid-19

Covid-19 continues to cause significant disruption across financial markets and has forced asset management firms and their service providers to execute their business continuity planning (BCP) programmes and remote working operations.

Despite today’s significant challenges, boards cannot let standards slip nor take short-cuts, otherwise the interests of investors risk being compromised.  Many fund directors, having experienced the 2008 financial crisis, are now better equipped to deal with the challenges presented by Covid-19.

They will need to maintain board effectiveness by monitoring and overseeing managers’ contingency efforts and assess whether or not they are effective. Boards should also be aware of investor enquiries and support them by probing managers about the operational resiliency of their critical service providers. In addition, directors must seek assurances from asset managers that they have credible back-up plans in place should their primary vendors encounter difficulties.

The social distancing measures are creating challenges for boards themselves insofar as they have not been able to meet physically. In response, directors have adapted by leveraging virtual communications technology and appear to be meeting more regularly as a result.

Boards will also be focusing extensively on the viability of the investment manager’s operations, key person risk and the quality and level of management information being provided to them in a timely fashion – including on valuation, liquidity, and the ability to deal with heightened redemption activity.

How will fund governance evolve?

There are no signs that fund manager governance standards will be allowed to relax. Investors and regulators continue to push for higher standards and there will be more consistency across fund types and domiciles. Evolving substance requirements in offshore jurisdictions mean directors will demand better quality information to oversee the fund.

Capacity, independence, and competence of directors will also continue to be prominent themes, and managers themselves will be under regulatory pressure to raise their own internal governance standards. Finally, more emphasis will be given to the environmental and social consequences of investments and how managers run their operations.

This article was first featured on Institutional Asset Manager: https://www.institutionalassetmanager.co.uk/2020/05/21/285801/has-fund-governance-improved-financial-crisis