September 20, 2020

The Editor Speaks: What steps are being taken in Cayman to make directors more accountable?


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Colin WilsonwebI am asking this question more especially to the hedge fund boards.

There is a tightening up of the banking rules in other financial jurisdictions but I haven’t heard of anything being proposed here in the Cayman Islands.

In a story in iNews Cayman today under iNews Briefs “Two HSBC directors said quitting over tougher bank accountability rules” the going ahead is too tough for some directors who in the United Kingdom will have to earn the huge sums of money they have been getting for doing almost nothing.

In an article published last July in The Press and Journal “Reckless bankers face jail sentences” it says, “In June, the Westminster-appointed Parliamentary Commission for Banking Standards set out its recommendations for legislative and other action – such as jail sentences – to improve professional standards and culture in the banking industry.

“The Bank of England’s Prudential Regulation Authority (PRA) yesterday set out its proposals for holding people to account.” (See

In April 2012 in an article by Jay Eisenhofer that appeared in Pionline “Hedge funds need more accountability”, the writer claims “Some serious ethical lapses show that new rules are needed to help investors and guide managers”.

Eisenhofer says,” In the past few years, hedge funds have moved into the mainstream of the U.S. economy. Once restricted to a small number of super-wealthy “sophisticated investors,” they now receive hundreds of billions of dollars from public and private pension plans acting as fiduciaries for school teachers, truck drivers, construction workers, first responders and others whom we have lately come to call “the 99 percent,” who share little in common with fund managers stocking the Forbes 400 list. Surfing upon this incoming tide of money, some individual funds now manage enough assets to exert significant influence in the markets.

“But the widespread acceptance of hedge funds among institutional investors has not been matched by commensurate improvements in their level of transparency, accountability and corporate governance. In recent months, we’ve witnessed the dismal result: a parade of inside-trading scandals evoking the fraud-riddled implosions of Worldcom, Tyco, Enron and Global Crossing that rocked corporate America a decade ago. It’s time for hedge funds to be brought into the 21st century and reflect their new broader role and fiduciary responsibilities. This means the legal regime that sets the rules for hedge funds must change.”

For the whole article go to:

In a 48 page article titled “Hedge Fund Boards” from Clifford, Ellis and Gerken” the writers say:

At the end of 2012, three-quarters of hedge fund assets were legally affiliated with an offshore domicile that required the fund to be governed by a board of directors. “In this paper we use a comprehensive dataset of filings to provide the first, large-scale examination of the governance role of hedge fund boards. We find that funds where managers have greater scope for conflicts of interest are more likely to have majority outside boards indicating that board may serve as a partial solution to agency concerns between managers and investors. We find evidence that outside board members serve as a certification mechanism that affects the capital allocation choice for investors. Despite their limited ability to replace a “bad” manager, directors use the threat of exit to align incentives ex ante. Upon the departure of an outside director, funds lose a significant fraction of their assets and increase the subsequent probability of failure. We conclude that despite claims in the media that hedge fund boards are perfunctory, funds and investors appear to consider the structure of hedge fund boards.

“Hedge funds are opaque, often complex, and lightly regulated. These characteristics increase monitoring costs and provide fertile ground for agency conflicts to emerge between hedge fund managers and investors. The symptoms of these conflicts have become evident following several recent studies documenting hedge fund misbehavior.1 These studies highlight the importance of understanding the governance mechanisms that hedge funds and their investors use to mitigate agency problems. In this paper, we examine the role that boards of directors play in the governance of hedge funds.

“Legally, the hedge fund directors have a responsibility to monitor managers and serve as an advocate for hedge fund investors. Hedge fund directors have explicit fiduciary duties to oversee matters where the interests of the manager and its investors differ. Directors monitor the manager’s risk management system and review the fund’s valuation practices, ensuring that NAVs are properly calculated. Further, they should review and approve investment advisors’ contracts and fees, side letter arrangements, discretionary liquidity restrictions, as well the selection of auditors, custodians, and other third party administrators.

“In practice, however, these tasks are complicated by several institutional features unique to hedge fund boards. Hedge fund directors are typically appointed by fund management and are not voted on by fund investors. These directors may be employees of the fund advisor or affiliated service providers. For those directors that are independent, many hail from large, professional service firms that specialize in providing hedge fund directorships. These ‘professional directors’ frequently serve on numerous boards at the same time, thereby calling into question both their impartiality and their ability to devote appropriate diligence for a given fund. Unlike corporate boards that may use the threat of firing the manager as a mechanism to align the incentives of mangers and shareholders, hedge fund boards typically lack the ability to fire the hedge fund manager. Motivated by the gap between the scope of the board’s responsibility and its perceived level of effectiveness, this paper empirically examines the structure of hedge fund boards and assesses the role (if any) that boards serve in shaping the contracting environment between investors and managers.

“The role of hedge fund boards has come under increased scrutiny following the wave of scandals and fund failures that emerged in the recent financial crisis. In particular, in 2011 the Grand Court of the Cayman Islands ruled that the directors of the defunct Weavering Macro Fixed Income Fund were to be held personally liable for $111 million in damages for failing to exercise independent judgment and appropriate due diligence in monitoring the actions of the fund. Following this case, several media outlets have published reports questioning the independence and monitoring capacity of hedge fund boards.

“Despite this increased attention, an empirical study of hedge fund boards is notably absent from the literature. The reason for this absence is likely two-fold. First, a common misconception is that all hedge funds are organized as limited partnerships (rather than corporations) and as such do not have boards. In fact, most hedge funds, even those organized domestically as LPs, create offshore corporate entities that give certain investors favorable tax treatment. The laws of offshore domiciles, such as the Cayman Islands, require the fund to establish a board of directors. The second reason, as is typical with hedge fund studies, is lack of data. Historically, hedge funds have faced limited disclosure requirements from the SEC. However, starting in 2009, the SEC mandated that hedge funds submit Form D filings electronically in a structured data format. For hedge funds seeking to raise capital from U.S.-based investors, these filings provide the names and addresses of the directors of hedge fund boards. We utilize these filings to create a comprehensive panel database of hedge fund boards from 2009 to 2012.

“We begin by documenting several stylized facts about hedge fund boards. Perhaps most interestingly, we find considerable cross sectional variation in the size and structure of hedge fund boards. Unlike for U.S. public corporations and mutual funds, few regulations govern the structure of offshore hedge fund boards. If boards were designed simply to meet the local regulatory minimum, then we would expect to see limited variation in board structure and significant clustering around regulatory minima. However, few boards meet only these minima (e.g. only 8.4% of Cayman Island boards meet only the regulatory minimum). Further, 79.1% of boards in our sample employ at least one director from outside the firm, while over half of boards consist of a majority of outside directors.

“Next, we examine how board structure varies with the contracting environment of the fund. We follow the vast literature on corporate and mutual fund board efficacy and focus on the role of board independence (a majority of the fund’s directors come from outside the hedge fund advisory firm). Outside directors should be less likely to be co-opted by the hedge fund manager, and thus more likely to act in accordance to their fiduciary duties, which is to protect investor interests from managerial misconduct. If boards are perfunctory then we should not expect to see any relation between outside boards and fund characteristics. To the contrary, we find that structure of hedge fund boards is broadly consistent with a characterization of boards as a partial solution to the agency problems that limit a fund’s ability to attract outside capital. Most notably, we find that outside boards are more common among larger hedge funds suggesting these outside boards could serve as a certification mechanism that funds use to signal their quality to outside investors. We also find that funds with outside boards have larger initial offerings, and funds that add outside directors receive large subsequent investments from a broader investor base.

“We also find that outside boards are more common in funds whose contracts allow greater scope for conflicts of interest between managers and investors. Classical agency theory would predict that fund managers with more discretion would require stronger monitoring mechanisms in order to attract outside capital. We find that funds are more likely to have outside boards when they value their assets internally, have less co-investment from the manager, and have longer withdrawal frequencies. Though these practices may be value increasing in some cases, they also afford the manager greater discretion or incentive to take advantage of investors. Further, when withdrawal frequencies are longer, investors are less able to “vote with their feet” (Fama and Jensen, 1983). Thus, these lock-ups impair the disciplinary role of investor flows, making alternative governance mechanisms (such as an outside board) more valuable. Taken together, our evidence is consistent with outside boards serving as a credible monitoring mechanism, helping to limit the potential opportunism associated with managerial discretion.

“Next, we then search for a mechanism outside directors can use to influence managers. An important distinction between hedge fund boards and the boards of U.S. public corporations is that hedge fund boards are (in most cases) completely appointed by the manager. As such, not only is the director’s independence from the manager in question, but they lack the authority to terminate the manager if he would misbehave. This arrangement raises the question, “what is the ‘stick’ directors can use to wield any monitoring authority?”

“We posit that a primary source of director authority comes from their ability to exit the board. Outside directors care about their own reputations, as many are professional directors that obtain their primary income from serving on multiple hedge fund boards. Thus, if a fund would fail under a director’s watch, the director’s reputation could suffer, affecting his ability to retain or seek new directorships from other funds. Similar to the finding in Brown, Goetzmann, and Park (2001) that fund failure greatly reduces future job prospects for fund managers, anecdotal evidence from press announcements of hedge fund board additions suggest a similar reputation effect for directors. We document that directors do face severe career consequences for being associated with failing funds. Directors associated with failure are nearly four times less likely to join a board after a fund failure, all else equal. As such, if a director observes that a fund manager is misbehaving or otherwise headed toward failure, the director has an incentive to exit the board and avoid having his reputation tarnished by being associated with a failed fund.

Given these incentives, investors could infer bad news from director departures and react by withdrawing their capital. This incentive effect has been documented for outside directors of public corporations by Fahlenbrach, Low, and Stulz (2013), who show that outside directors tend to leave before poor company performance and investors react negatively to this news. In this manner, a director could derive de facto authority by serving as a certification mechanism. Ex ante, the threat of exit could serve as a governance mechanism, restraining managers who are wary of losing the director’s certification (similar to the role of blockholders in Edmans, 2009).

“In a press announcement announcing the addition of the one of our sample directors, Greg Bennett, to the Oceanic Hedge Fund board explicitly cited his clean track-record both in terms of regulatory violations and fund failures: “[Mr. Bennett never has] had any public criticism by statutory or regulatory authorities (including recognised professional bodies)” and ” [Mr. Bennett never has] been a director of any company which, while he was a director with an executive function or within 12 months after he ceased to be a director with an executive function, had a receiver appointed or went into compulsory liquidation, creditors voluntary liquidation, administration or company voluntary arrangements, or made any composition or arrangements with its creditors generally or with any class of its creditors”

Consistent with a disciplinary role of director departures, we find that funds suffer large outflows when outside directors leave the board, especially if the departing director is not replaced by another outside director. These results suggest that investors view director exits as a negative signal about the future prospect of the fund. We then test whether investors are correct in perceiving negative information from an exit by examining whether the probability of fund failure is higher following director exits. We find that the loss of an outside director increases the likelihood of failure from two to nine times depending on whether the fund replaces the director. “Although the evidence is circumstantial, our results are consistent with the idea that the director’s option to exit the board may be the ‘stick’ of hedge fund board governance.

“To the best of our knowledge this paper is the first to examine hedge fund boards.”

The writers conclude:

“Following the recent wave of scandals and failures in the hedge fund industry, considerable debate emerged to whether hedge funds employ suitable governance practices to protect investors. One aspect of hedge fund governance that has come under increasing scrutiny is the board of directors. Hedge fund directors have fiduciary duties to protect investor interests by monitoring the operational practices of hedge fund managers. However, the directors are selected by fund managers and have significantly less explicit authority than the directors of traditional corporations. As such, a common conception is that hedge fund boards are irrelevant rubber-stamps that serve little purpose other than to superficially satisfy offshore regulations. In this paper, we examine the structure of hedge fund boards and their relation to fund characteristics and investment using a newly created dataset of fund available from 2009 to 2012.

“We find that, though some funds install a board comprised only of insiders, over three quarters of funds have at least one outside director, and over half of funds have a board with a majority of outside directors. The variation in board structure is in part explained by fund characteristics that are consistent with boards serving as a partial solution to agency problems. Given their limited ability to remove the manager, we search for a channel by which directors can influence managerial behavior. Given the severe career consequences for a director being associated with failing funds, our evidence suggests that directors may derive implicit authority from their ability to exit the board.

“Board structure is ultimately choice of the fund manager; as such, we are cautious to present causal interpretation regarding board monitoring. That said, at a minimum, our findings contradict the notion that hedge fund boards are irrelevant. We believe this paper provides a first step towards better understanding the role of boards of directors in the governance of hedge funds.”

To read the whole paper go to


A notable case that involved Ernst & Young Cayman Islands was the one in 2008 held in New York’s Supreme Court when they were sued by THEO BULLMORE and PHILLIP S.STENGER, as Joint Official Liquidators of BEACON HILL MASTER LTD.

Ernst & Young won the case and the background was:

“In August of 2002, Beacon Hill Master Ltd. (the Fund), a hedge fund organized under Cayman Islands law, sustained heavy trading losses and ultimately “imploded.” In 2004, the Grand Court of the Cayman Islands appointed plaintiffs Theo Bullmore and Phillip Stenger as the joint official liquidators () of the Fund, pending winding-up proceedings (CI Proceedings), to pursue claims on behalf of the Fund.

“The Fund, that invested primarily in mortgage-backed securities, was formed in 1997 by defendant Beacon Hill Asset Management, LLC, and its principles, the four individual defendants John Barry, Thomas Daniels, John Irwin, and Mark Miszkiewicz, that acted as the Fund’s investment manager (together, the ).

“In early October of 2002, the Investment Managers advised the two independent directors of the Fund’s board, non-party Don Seymour and Peter Young (Directors), that the Fund had suffered the loss of nearly half of its net asset value.

“Bear Stearns, the Fund’s broker, also learned of the Fund’s dramatically deteriorating financial condition around this time, and determined that it would discontinue financing to the Fund. On October 8, 2002, Bear Stearns alerted the Securities and Exchange Commission (SEC) of the Fund’s condition.

“On November 7, 2002, the SEC commenced an action against the Investment Managers for securities fraud, based upon allegations that the Fund’s losses were precipitated by the fraudulent valuation methods that they employed.  The Investment Managers denied any wrongdoing, but agreed to the entry of a consent judgment against them, and to step down as the Fund’s manager.

In March of 2005, the JOL commenced this action on behalf of the Fund against the Investment Managers, , and the Fund’s administrator, ATC Fund Services (Cayman) Limited (ATC).

“The JOL allege that the Investment Managers fraudulently inflated the value of the securities held in the Fund’s portfolio, that ultimately led to the Fund’s collapse in late summer of that year, when growing and substantial losses could no longer be hidden by manipulative valuation.

All of the defendants have since settled with the JOL, with the exception of EYCI. It is the sole defendant in this action. EYCI was retained as the Fund’s auditor pursuant to an engagement letter (Engagement Letter), and conducted the Fund’s only audit based upon the period of time between January 2 and March 31, 2002.  EYCI issued a “clean audit report.”

“The complaint alleges that EYCI conducted a deficient audit by failing to perform the audit in accordance with generally accepted auditing standards. Additionally, the JOL allege that EYCI was negligent in failing to detect the Investment Managers’ fraudulent valuation and alert the Directors, thereby causing the Fund’s losses.”

The valuation scheme was determined as a fraud. However, the judge was not very forgiving over the role paid by the directors of JOL. He said:

“Nonetheless, even if the court were to adopt the innocent insider analysis merely to facilitate its own consideration of causation, the JOL fail to raise a triable issue of fact that EYCI’s failure to alert the Directors ultimately caused the Fund’s losses.

It is undisputed that the Investment Managers exercised nearly unfettered control over the Fund’s day-to-day activities and operations, and made all investment decisions for the Fund, including the valuation methods employed, and obtaining and retaining subscriptions from investors (Complaint, ¶¶ 1, 12-15,

23; Plaintiffs’ Rule 19-A Counter-Statement, ¶ 50).

“The Directors did not participate in any meaningful aspect of the management or decision-making of the Fund, but delegated all management responsibilities and duties to the Investment Managers, had minimal communication with the Fund’s investors, and performed largely “minor administrative tasks” (EYCI’s Rule

19-A Statement, ¶¶ 33, 35, 50-51; Plaintiffs’ Rule 19-A Counter- statement, ¶¶ 71, 73-74, 77; Transcript of Seymour Deposition, 75:21-24; 77:3-5, 102:21-22; Young Deposition, 84:20-25, 141:8-17).

“The Independent Directors did not hold a single meeting from the day that the Fund was created in January of 2002, or have any interaction with the Fund’s administrator, until October 7, 2002, when the Investment Managers reported the NAV discrepancies to the entire board (Transcript of Seymour Deposition, 102:23-25, 103:2-16, 17-20, 188:11-25, 189:2-5). Further, they did not receive any financial reports from the Investment Managers or monitor the Fund’s investments (id.).

In total, the Directors devoted “not a lot of time” to the Fund, and estimated that the time actually spent performing tasks on behalf of the Fund was “probably a few hours at best” (id., 104:18-24).

“The Directors also admit that they did not review the financial statements prior to EYCI’s audit (Transcript of Seymour Deposition, 180: 20-22, 187:16-25, 188:2-5, 192:11-20).

“Nonetheless, they signed a representation letter (Representation Letter) to EYCI attesting to the conformity of the financial statements prepared by EYCI with generally accepted accounting principles (id.).

“From these undisputed facts, it is impossible to reconcile the JOL’s assertion, and Seymour’s testimony, that the Directors would have acted to stop the fraud and immediately remove the Investment Managers had EYCI had alerted them of the valuation discrepancies (Transcript of Seymour Deposition, 288:12-19).

“This contention is speculative and unsupported by the factual record.

The Directors took no action subsequent to learning of the NAV discrepancies on October 7, 2002, either by conducting an investigation or removing the Investment Managers. Bear Stearns, the Fund’s broker – and not the Directors – contacted the SEC after the NAV discrepancies were disclosed (Transcript of Barry Deposition, 67:2-4; Daniels Deposition, 121:13-16). Thereafter, the Investment Managers agreed to resign as part of a consent decree entered in the SEC Action.

“Thus, even assuming arguendo that the Directors were “innocent,” insofar as they did not actively participate in the alleged valuation scheme, the JOL fail to raise a triable issue that they were innocent decision-makers capable of stopping the Investment Managers’ wrongdoing. The Directors’ conduct throughout their tenure at the Fund indisputably demonstrates their passivity.

“In any event, the court rejects the argument that the Directors are “innocent” for several reasons. The undisputed evidentiary record demonstrates that the Directors ceded control of the Fund to the Investment Managers, permitted them to

operate the Fund with impunity until they were removed by the SEC, and appear to have ignored their own responsibilities to the Fund by failing to review the financial statements, despite attesting to their accuracy in the Representation Letter.

Judge Posner recognized that passive corporate actors should not be granted a carte blanche to shift the cost of management’s wrongdoing to the corporation’s accountant, in the landmark decision in Cenco Inc. (686 F 2d 449). That action involved a fraudulent scheme that permeated top management to inflate the corporate inventory beyond its actual value (id.). After the fraudulent scheme was unearthed, the corporation, under new management, sought to assert claims against the auditors for malpractice (id.). The court reasoned that even passive stockholders that did not directly participate in management’s scheme were, nonetheless, culpable to some degree as a result of their election of board members that later engaged in wrongdoing, and by their own passivity in failing to supervise them (id. at 455-56).

“Thus, in apportioning the burden of fault, the court determined that, while the accountant may have “failed to police its people, Cenco [the corporation] failed as or more dramatically to police its own.”

I apologise for the length of this Editorial today but it was necessary as I am NOT an authority in any way on legal matters especially involving banking.

In digesting all the above I ask you again, “What steps are being taken in Cayman to make directors more accountable?”

Unless we do the still bandied adjective in describing the Cayman Islands by the US media, “notorious”, will never go away.






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