The period since September 2008 has focused attention on the ability of investors in investment funds to influence or direct the manner of operation of the fund in which they are invested (or the lack thereof). Investment funds facing decreasing liquidity in their portfolios and a significant increase in redemption requests (and potential difficulty in obtaining accurate net asset valuations for certain portfolio assets) used a variety of techniques to prevent significant redemptions.
In some instances, it could be said that investment managers or their advisors took an aggressive interpretation of the fund's constitutional documents. Actions were taken that some investors saw as an attempt on the part of the investment manager to protect their own interests (by maintaining an asset and therefore, fee base) rather than those of the fund's investors.
The most common mechanics employed were: suspending redemptions; side-pockets (real and synthetic); using redemption gates; and implementing redemptions in kind. While the latter two tended to be more explicitly addressed in fund documentation and were less controversial when implemented, suspending redemptions for extended periods of time and using side-pockets mechanics, where not subject to investor approval, on occasion gave rise to grievances. Boilerplate clauses in fund documentation that had rarely received attention fell under the spotlight.
With suspensions, the controversy often arose from the wide discretion given to the directors or investment manager when deciding when to implement a suspension and in determining its duration.
Using side-pocket mechanics to 'convert' a portion of an investor's previously redeemable shares into non-redeemable or heavily restricted shares (potentially also with a revised fee basis or reset high-water mark) was also a cause for concern for investors, who felt their rights were adversely affected by the different liquidity terms and fee arrangements imposed. This was particularly the case when synthetic side-pocket mechanics were used to 'work around' documentation that did not explicitly include such mechanics.
Limiting Investor Powers
The standard structure for a Cayman Islands corporate investment fund is for investors to be issued participating shares that are non-voting and only have limited protective class rights. This means that investors in most instances have no ability to appoint and remove directors or the investment manager. In addition, the investors have no ability to call for a general meeting and limited ability to place the fund into liquidation.
Even if the shares held by an investor have voting rights, there are practical difficulties for an investor in pursuing a shareholder resolution to wind up the fund where the investor does not know the identity of the fund's other investors and does not hold sufficient shares to requisition a shareholders' meeting or to ensure that a winding-up resolution is passed at such a meeting.
One possibility is for a disgruntled investor to present a winding-up petition on just and equitable grounds on the basis of loss of substratum (that the purpose for which the company was established has failed) against a fund where redemptions remain suspended. How such an application will be dealt with by the court will depend on the facts of each case, but considerations such as the length of the suspension, the stated reasons for the suspension remaining in place, any proposals to permit redemptions and the views of the investors would all be relevant. However, expense and timing are deterrents to pursuing such a course of action in many instances.
Although investors are now likely to be more aware of the possible application of provisions they previously thought to have little practical relevance (except in cases where a lead investor is being courted before launch that imposes specific stipulations on the fund structure), fund documents being prepared now may not differ significantly in terms of restricting the discretion of the investment manager and directors from those produced prior to these issues being highlighted.
If anything, documentation that has been found by investment managers and directors to be restrictive and which made it difficult for them to 'stabilise' or restructure the funds they governed without investor approval may now have been revised to give them more discretion.
The likelihood of wholesale amendment of established formats of investment fund documentation is probably unlikely and perhaps not desirable. So, what should a prospective investor, dissatisfied with their prior experiences but who still wishes to participate in the investment programmes offered by offshore investment funds do? Questioning independence.
While the view may be taken that it is often a fund's investment manager who determines whether it is appropriate to implement suspension and other mechanics, the final decision is ultimately the directors' responsibility and directors must ensure they comply with their fiduciary duties by acting in good faith in the best interests of the fund, as well as acting for a proper purpose and treating all investors fairly.
In these circumstances, consideration needs to be given not only to the provisions included in the fund documentation but to the identity of the people who are in the position to exercise such provisions. This brings into focus the role of independent directors in protecting the interests of shareholders, where shareholders have limited rights or no practical means of enforcing the rights that they do have. Independence may be regarded as a director not being in the employment of and having no significant financial interest in the fund's investment manager or its affiliated companies.
However, the definition of independence may have to be expanded to include the requirement that the director does not have any other direct or indirect involvement with the fund or its service providers or advisers. For one, it must be questioned whether the fund's legal counsel (or employees of a related service company) qualify as independent when they almost certainly acted on the instruction of the investment manager in connection with the fund's formation and in many instances will have done so in respect of multiple funds managed by the investment manager.
While it may seem that it would always have been the case, following the difficulties of 2009, ensuring that a fund has independent directors who require the fund to be properly structured (having regard to investors' interests), exercise active oversight of key aspects of the fund's operations and will proactively seek to advance investors' interests may now be a fundamental consideration for prospective investors.
Alan Craig is a partner in the Corporate and Commercial Department of Campbells Attorneys-at-Law and has worked on Cayman fund matters since 1999. He was admitted as a solicitor in England and Wales and to the New York State Bar prior to relocating to the Cayman Islands.
This article first appeared in HFMWeek (Pg 21, Cayman Report 2010 issue). For more details, please visit www.hfmweek.com.