United States: Private Sector Consultation Paper Dated July 16th 2013 ("July Consultation"): Corporate Governance Statement Of Guidance For Mutual Funds ("Guidance")

Mrs. Cindy Scotland, Managing Director
The Cayman Islands Monetary Authority
Elizabethan Square,
P.O. Box 10052, Grand Cayman KY1-1001
Cayman Islands

BY HAND

WITHOUT PREJUDICE

August 15th 2013

Dear Madam

PRIVATE SECTOR CONSULTATION PAPER DATED JULY 16TH 2013 ("JULY CONSULTATION"): CORPORATE GOVERNANCE STATEMENT OF GUIDANCE FOR MUTUAL FUNDS ("GUIDANCE")¹

This letter contains the responses of DMS Offshore Investment Services (DMS) to the July Consultation and Guidance. We are delighted to finally engage with the Authority on this important matter. We are writing directly to the Authority, given our professionals' and stakeholders' collective position as a major stakeholder in the fund governance industry and the unique issues that exist between DMS and the Authority. We are copying this letter to certain of the Private Sector Associations and Sectors to which the July Consultation and Guidance was sent because our professionals are members thereof. Also, because this consultation process is open to the public, we are publishing this letter on our website to provide transparency into our views for all industry stakeholders.

DMS supports principles-based regulatory Guidance

DMS reiterates its long standing support of effective fund governance regulation and believes that directors should be regulated (authorisation, supervision and enforcement) in the same manner as the other service providers to a regulated mutual fund, under the Mutual Funds Law (2012 Revision) (as amended) ("Mutual Funds Law") as intended. Principles based guidance is a useful step towards this objective and we commend the Authority's recent decision to address the issue of fund governance for 99%^2.

Fund governance needs are very different than those of other companies

of regulated mutual funds ("Regulated Mutual Fund/s") separately from that of corporate governance of other regulated financial services. This is a significant improvement from the Authority's initial proposal to include all fund governance within the scope of the Corporate Governance Private Sector Consultation Paper dated January 14th 2013 ("January Consultation"). It is important for the Authority to recognise that corporate governance and fund governance are not the same and each requires a distinct approach. Acknowledging these differences may help the Authority to bridge the expectations gap within the industry. First, not all funds are structured as corporations, so a pure focus on structure ignores the fundamental aspect of function. Second and most importantly, a corporation is, by definition, a "body of people" and a typical Regulated Mutual Fund does not have any employees. A Regulated Mutual Fund is operated by its directors through various service provider delegates and the employees of a service provider to a fund are not employees of the fund. Each service provider has its own governing body, independent of the fund and it is generally ultra vires for the directors of a fund to direct the actions of any employee of a service provider. The nature of the relationship and the responsibilities of the service provider (and its associated employees) are contained in the terms of the service provider agreements with the fund. The function of the directors of the fund is to properly operate the fund in accordance with those agreements. That is the essence of fund governance and the Authority should recognise that this is fundamentally different from the corporate governance of a typical corporation, where directors have direct oversight and authority over employees and their work. While some similarities exist, any effort to equate these two is deeply flawed and fails to comprehend the nuances and unique aspects of hedge fund structure and operation.

DMS stakeholders

As the worldwide leader in fund governance, our professionals and the stakeholders we represent have much at stake regarding the Authority's regulation of Corporate Governance of Regulated Mutual Funds ("Fund Governance"). Any changes made by the Authority may have a direct bearing upon our business practices and, potentially, our competitiveness within the global financial services marketplace. Our professionals are dedicated to providing fund governance services by serving in their personal capacity as directors of Regulated Mutual Funds and also representing our subsidiary, DMS Fund Governance Ltd. ("DFG") – which holds a full mutual fund administrators licence – and its subsidiaries which serve as directors to such entities. These directors are supported by a team of associate directors and associates and our proprietary fund governance technologies. DMS voluntarily adopted the SEC's fund governance standards in 2004 and these principles have guided our work to deliver an exemplary track record of success for our stakeholders. In our now 13 year history, we have not suffered any criminal, civil or administrative judgments, censures, settlements, disciplines or investigations of any kind.

Institutional approach

With more than 200 people and our renowned institutional process, DMS has the largest capacity in the industry and successfully operate more fund directorships than anyone else in the world. Our market-leading size and position is a major advantage to the fund stakeholders we serve and DMS represents leading funds with AUM exceeding $330 billion. The DMS institutional governance approach is consistently selected by sophisticated fund stakeholders in a highly competitive market and DMS represents the largest number of regulated mutual funds and stakeholders in the industry. We are bound to advocate these industry viewpoints to the Authority and, in summary, we respectfully request the Authority to revise the Guidance as follows:

1. Reflect The Appropriate And Rational Expectations Of All Stakeholders.
   
   
   1. DMS's specific comments on the Guidance. The Guidance should reflect established law and realistic expectations of the majority of hedge fund stakeholders regarding fund governance, not the agenda of an infinitesimally small special interest group or irrelevant standards or unscientific surveys.
   2. Fund Governance is not deficient. There is substantial evidence to support the proposition that Fund Governance in the Cayman Islands is already appropriate, rational and well understood and that investors already have appropriate legal recourse against directors who breach their fiduciary duties.
   3. Inappropriate increase in burdens, risks and costs. The Guidance, as presently drafted, would impose substantially greater burdens, risks and costs on a regulated mutual fund and an independent non-executive director than currently exists.
2. Broaden Scope.
   
   
   1. Licenced Mutual Funds. The Guidance should apply to all Regulated Mutual Funds, i.e. registered, master, administered and licenced, without excluding the latter.
   2. Sole Corporate Director. The Guidance should reaffirm that a Regulated Mutual Fund may have a sole corporate director, which is a Licenced Mutual Fund Administrator ("LMFA") or wholly owned subsidiary thereof as permitted under the Mutual Funds Law.
3. Enforcement Action Must Not Offend the Constitution's Bill of Rights.
   
   
   1. The Authority should not take any enforcement action against a regulated mutual fund or its directors for alleged infraction of the Guidance without a fair hearing.
   2. That is, the Mutual Funds Law should be amended to ensure that there is a complaints procedure which can be referred to an impartial disciplinary tribunal which would afford the parties the right to a fair hearing with the right of appeal to the Grand Court – Financial Services Division.
   3. This is imperative because all decisions and acts of public officials must be lawful, rational, proportionate and procedurally fair.

Reasons

Our reasons for the above submissions are set out below:

1. Reflect The Appropriate And Rational Expectations Of All Stakeholders.

DMS's Specific Comments on the Guidance. The Guidance should reflect the established law and realistic expectations of hedge fund stakeholders regarding Fund Governance, not the agenda of an infinitesimally small special interest group who seek to have directors act ultra vires of their obligations under Cayman Islands law, which requires them to act in the best interest of the fund, not any particular investor. Nor should the Authority seek to act for those few stakeholders that implore the Authority to "reallocate the market". Such actions would be illegal uses of the Authority's power and, while we accept that the Authority has broad discretion under the Mutual Funds Law and Monetary Authority Law, neither broad discretion nor good intentions is an excuse for abuse. The Authority is bound to be sober and fair minded in its work and, as a public institution, the Authority must, at all times, be impartial and make fact-based decisions to maintain the public trust and confidence. The Authority must remain neutral, act with caution and care and not advocate for one service provider over another.

The wrong message

Misuse or overreach of the Authority's power would send the wrong message to the business community, putting the Cayman Islands at risk of losing jobs and damaging its reputation and economy. The Mutual Funds Law and Monetary Authority Law should be applied appropriately – not stretched or abused to favour any special interests. This concern is not theoretical as studies³ have shown that "the unpredictable nature of the legal [regulatory] system" is a major factor undermining competitiveness as a global financial centre and that "attractiveness to international companies" is diminished by the "perception that penalties are arbitrary and unfair".

US approach to Fund Governance

It is puzzling – yet instructive – why the Authority fails to make one single mention of the United States Securities and Exchange Commission's (SEC) views on governance, such as its pillars of investor protection⁴ or its fund governance standards⁵, in either of the Consultation papers, and completely ignores these considerations in formulating this Guidance; when nearly 80% of hedge fund assets are managed by US based managers and the majority of stakeholders in Cayman Islands regulated mutual funds (hedge funds) are US based. The SEC generally requires hedge fund managers to be registered and operate their funds within what are widely believed to be the strongest regulatory standards in the industry. Locally it is commonplace for service providers, such as auditors and administrators, to voluntarily comply with SEC standards in their work in an effort to maintain best practice standards. Has the Authority even considered these standards in promulgating this Guidance? Instead, as dissected below, the Authority seems to have arbitrarily selected a few arcane and irrelevant data points that defy logic and serve only to perpetuate a false narrative that Fund Governance is deficient in the Cayman Islands.

DMS is highly engaged with the hedge fund industry. We conduct thousands of hedge fund board meetings every year plus tens of thousands of interactions with hedge fund stakeholders annually. IOSCO standards have not been raised as a concern in these board meetings or any interactions by any stakeholder. IOSCO standards remain on the fringe of an industry dominated by mainstream regulatory issues promulgated by national regulators such as the SEC, CFTC, FCA and SFC. It is highly questionable why the Authority would seek to subject regulated mutual funds to substantial increased costs by imposing on them esoteric standards of no discernible value or benefit to industry stakeholders. This is one of the risks of relying on hastily and improperly conducted surveys: i.e. if the right questions are not asked, of the right people, the right answers will not be found.

Is it necessary?

IOSCO international standards are intended to fill the gap where no national standards exist and imposing these standards on an industry already heavily regulated from the recent tsunami of national regulation would be duplicative at best or dubious at worst. The key test should be, "is it necessary?" While implementing international regulatory standards is a commendable conceptual goal, the day-to-day reality is that hedge fund stakeholders are most concerned with complying with the rules of national regulators. This is what keeps the industry up at night. For instance, the Commodity Futures Trading Commission (CFTC) has no vote within IOSCO as an associate member, yet the CFTC is one of the most dominant and widely respected regulators in the hedge fund industry.

As reported in the UK press, it also surprising that the Authority did not solicit the views of the leading hedge fund law firms⁶.

Taken together, the Authority has failed to show how excluding the standards and viewpoints of the leading national regulators and hedge fund law firms, two key stakeholders within our most important market, meets the Authority's obligations under Section 6(2) and 6(3) of the Monetary Authority Law. in the United States who are most influential in guiding the decisions of sponsors on establishing and operating hedge funds in various jurisdictions.

While DMS believes that effective regulation of fund governance as intended under the Mutual Funds Law is prudent for the continued development of the industry in a safe and sustainable manner, the Authority has not addressed this issue – meeting the appropriate and rational expectations of all stakeholders – nor has it presented a convincing case for the reforms it seeks. Based on our careful examination of the evidentiary information disclosed by the Authority in its two Consultation papers, survey and its other public disclosures, we are deeply concerned that the Authority, in pursuing these reforms, has wholly and imprudently relied on: (1) the narrow, conflicted views of a vocal, but infinitesimally small number of investors – without verifying the veracity of their allegations in accordance with the principles of natural justice; and (2) intellectually or statistically irrelevant studies or surveys. This creates a real possibility of bias; yet the Authority continues to cite this counterfactual information as authoritative, without presenting the Public Sector with any evidence that this information has been properly investigated and verified.

Our specific comments on the Guidance appear in Exhibit DMS1 – Specific Comments on the July Consultation. These are subject to our general comments below.

1. Fund Governance is not deficient. We, like most in the industry other than the infinitesimally small special interest group previously mentioned, are perplexed why the Authority considers that Fund Governance is deficient in the Cayman Islands. Anyone, anywhere in the world can serve as a director of a Regulated Mutual Fund and there are more than 10,000 directors currently serving Regulated Mutual Funds worldwide, of which only approximately 250 are based in the Cayman Islands. There is substantial evidence – the Islands' position as the global jurisdiction of choice for Regulated Mutual Funds, the large number of directors available in the market, twenty years of case law and the IOSCO report itself – to support the propositions that Fund Governance is already appropriate, rational, well understood and that investors already have appropriate legal recourse against directors who breach their fiduciary duties.
   
   
   1. Success of the Islands' Regulated Mutual Fund business.
      
      
      1. The Cayman Islands are the leading offshore jurisdiction for Regulated Mutual Funds. According to the Authority's website, there are now 11,209 Regulated Mutual Funds. The annual growth since 2005 was 14% in 2006, 16% in 2007, 5% in 2008, down 4% in 2009, down 1% in 2010, down 2% in 2011, up 17% in 2012 with the registration of 1,891 master funds and up another 3% as of June 30th 2013. This is particularly impressive in light of the global financial crisis in 2007–2009.
   2. Cayman case law.
      
      
      1. Fund Governance in the Cayman Islands is already robust and well understood and has been for many years by virtue of the common law, the existing regulatory framework and the high quality of the Islands' judiciary and legal profession. Stakeholders have recourse to the Authority or to the Cayman Islands courts for any instances of wrongdoing from directors. Indeed, the reputation of the Cayman Islands' legal and judicial system is one of the primary reasons Regulated Mutual Funds are in such high demand by hedge fund promoters and investors worldwide. We can illustrate the good health of Fund Governance in the Islands by pointing to the results of a simple search for reported cases with the words "fund" and "director" in the Cayman Islands Law Reports freely available on the Judicial & Legal Information Website⁷. The results are attached as "Exhibit DMS2: CILR Search".
      2. Exhibit DMS2 reveals that since the Mutual Funds Law was first enacted in 1993, over twenty years ago, there have only been 80 reported cases in the Cayman Islands which include both the words "fund" and "director". These include 58 cases at first instance; 35 cases in the Grand Court and 23 cases in the Grand Court, Financial Services Division (including the now famous Weavering case). That is, on average there have been less than three cases per year. Seventeen cases went to the Court of Appeal and four cases made it to the Judicial Committee of the Privy Council. Those numbers would be smaller for those actually concerning breach of fiduciary duties by a director of a Regulated Mutual Fund, but this simple analysis makes the point.
      3. Further, the Authority has brought 13 enforcement cases to date against Regulated Mutual Funds for breaches of the Mutual Funds Law and Companies Law (2012 Revision) (as amended). All enforcement cases resulted in the Authority cancelling the offending mutual funds' registration to operate in the Cayman Islands. It is instructive that all 13 of these enforcement cases involved non-professional directors based outside of the Cayman Islands.
      4. The enforcement data from the Authority provides two significant revelations.
      5. First, these 13 enforcement cases do not include the famous Weavering case that also involved non professional directors based outside the Cayman Islands; because the Authority has inexplicably not taken any enforcement action against these directors despite the Grand Court's ruling in August 2011 – exactly two years ago. To date, the Weavering Fixed Income Macro Fund maintains a valid Certificate of Registration #6838 to operate as an active regulated mutual fund in the Cayman Islands⁸ Such inaction and selective application of the Mutual Funds Law is incompatible with pursuing effective fund governance reform.
      6. Second, these 13 enforcement cases do not include any cases of misconduct of Cayman Islands directors during the global financial crisis – as alleged by some and adopted as a dictum of the Authority for pursuing fund governance reform. If the Authority has evidence of director misconduct, why hasn't the Authority taken enforcement actions against these perpetrators? Also, why were no cases brought by stakeholders in the courts as discussed above? These are important unanswered questions that the Authority is bound to comprehensively answer for all stakeholders.
      7. It would be erroneous for the Authority to suggest that it has sufficient basis for fund governance reform, but insufficient basis for taking enforcement action. Both of these cannot be true at the same time. The Authority is duty bound to properly investigate any allegations of director misconduct. It should not blindly rely on anecdotes and accept them at face value without fully investigating them in accordance with the principles of natural justice. Trust but verify. Even if the allegations prove credible, then surely it would be more rational for the Authority to use its enforcement powers to single out and punish the offenders, rather than striking the entire industry with common regulation to solve an uncommon problem. It is strange and unprecedented that, in its pursuit of fund governance reform, the Authority has disregarded its own established practices by first proposing a range of regulatory 'solutions', without first investigating and understanding the nature and extent of any problems that may exist.
      8. Based on these statistics, underscored by the fact that they include the period of the worst financial crisis in our history, we do not understand why the Authority considers that Fund Governance in the Cayman Islands is deficient. Surely there would be substantially more enforcement cases in the Authority or the courts involving Cayman Islands based directors if Fund Governance was deficient.
   3. IOSCO.
      
      
      1. The Authority has placed inappropriate and irrational reliance upon the IOSCO Objectives and Principles of Securities Regulation⁹ ("IOSCO Principles") as a basis for reform of Fund Governance¹⁰. The Authority made an inaccurate and misleading statement¹¹ by suggesting that IOSCO's recommendations expect higher corporate governance standards from hedge funds, whereas the focus of the IOSCO Principles is almost exclusively on hedge fund managers/advisers and their exposure or contribution to systemic risks in the financial markets. The IOSCO Principles' focus is decidedly not on the protection of hedge fund investors by imposing greater fiduciary duties on hedge fund directors. We have summarised The Key Questions of IOSCO's Principle 28¹² in Exhibit DMS3 – Ten Key Questions under IOSCO Principle 28.
      2. Essentially, only Key Question 8 has any direct bearing on a hedge fund and, by extension its directors, and even that provision applies equally to the hedge fund's manager/adviser. Key Question 8 provides:
         
         
         "Supervision and enforcement
         
         8.(a) Does the regulatory system provide for ongoing supervision of the hedge fund managers/advisers which are required to register?
         
         (b) Does the regulator have the power to access and inspect the hedge fund managers/advisers and their records and/or the hedge funds?
         
         (c) Does the regulator have the authority to enforce against wrongdoers?"
      3. Thus, IOSCO's only implication for the Authority in terms of the regulation of Regulated Mutual Funds is that 8(b) recommends that the Authority should have power to access and inspect their records. The Authority already has this statutory right in prescribed circumstances¹³. If these circumstances are too narrow, it may be that the Mutual Funds Law should be further amended. In any event, the Authority already has enforcement powers under §30(3) of the Mutual Funds Law which should satisfy the recommendation in 8(c) quoted above.
      4. In the circumstances, it is inappropriate and irrational for the Authority to rely on the IOSCO Principles for the Guidance. Every single point the Authority makes in the Guidance that is sourced from the IOSCO Principles was intended by IOSCO to apply to hedge fund managers/advisers and not to hedge funds or their directors. Every single one of those points must be substantially modified to clarify that the directors of Regulated Mutual Funds' role is high-level oversight of the functions of their delegates, including the investment manager/adviser and the usual service providers.
      5. Neither IOSCO nor the common law imposes any expectation or obligation upon nonexecutive directors of Regulated Mutual Funds to continuously monitor investment performance and risk management. Those functions are delegated to the Investment Manager which is in a position to monitor these issues "real time"; the directors are not, so it is unfair and irrational to impose this responsibility, and therefore liability, on them. The EU AIFM Directive for instance, imposes risk management functions on the AIF Manager, not on the AIF itself¹⁴.
   4. Survey Results.
      
      
      1. Bad facts make bad law and it's evident that the Authority's survey results are arbitrary – taken from statistically unrepresentative samples of the entire population of investors, investment managers, administrators and directors. The mere fact that the Authority's powers affect rights or interests obliges it to act within natural justice principles. Such principles require that legal decisions can only be legitimately based on survey research if data collection uses proper scientific methods and the studies are neutral, valid and understandable. The Authority has provided no information whereby the Private Sector can evaluate the integrity of the survey process. The Authority's July Consultation indicated that 86% of the 28 investors who responded to the Survey thought the industry would benefit from some improvement on corporate governance practices. However, those 24 investors represent at most about 0.002% of the total investor population in Regulated Mutual Funds of more than 1.8 million¹⁵. We submit that this finding is infinitesimally small, unscientific and disproportionate by any measure. To extrapolate this mediocre finding and promote it as conclusive evidence for a rational decision would be reckless.
         
         Alternative view
         
         Thus, we would challenge and counter the Authority's shocking extrapolation and assertion that 86% of investors think Fund Governance needs improvement with the assertion that at least 99.998% of investors are satisfied with Fund Governance "as is". As explained above, the responses to the Authority's survey are statistically insignificant and therefore cannot rationally be taken to represent all investors or form any basis for any rational decision. That is not to say that the respondents' opinions should be dismissed. All opinions are valuable and appreciated, but rather it is clearly an unsafe and unreasonable assumption for the Authority to posit that these respondents are truly representative of all the persons in their class.
      2. This means that the Authority's decision to treat the collective opinions of the sampled investors as an accurate representative of the entire population of investors is fundamentally flawed, inappropriate and irrational.
2. Inappropriate increase in burdens, risks and costs. The Guidance as presently drafted would impose substantially greater burdens on the directors of a Regulated Mutual Fund, resulting in substantially greater costs to the fund since directors are paid by the fund. While the Guidance would result in significant benefits for DMS and other service providers by increasing our revenues from additional governance services, this short-term benefit would come at the expense of the long term sustainability of the industry. It is highly questionable whether the proposed increased burdens, which are of limited to no incremental value, would justify the significant increased cost in an industry where the majority of funds are small – 68% being less than $100m – and funds are already facing challenging market conditions. These increased costs would factor significantly into total expense ratios and make it more difficult for funds to remain competitive. The Authority has not made any cogent argument to support what benefits would accrue to the investors in these funds that would be worthwhile to outweigh these increased costs.
   
   Funds and their directors' reputations are inextricably linked
   
   The Guidance would also vastly increase the reputational risks the Regulated Mutual Fund and its directors would face. It's unreasonable to believe sanctions under the Guidance can solely impact the director but not the Regulated Mutual Fund. The two parties are inextricably linked. The Guidance is, after all, attempting to hold the director responsible for the conduct of the Regulated Mutual Fund. The Authority could use an alleged infraction of the Guidance to sanction a director or a Regulated Mutual Fund where conduct does not breach the fund documents or fiduciary duties owed to the Regulated Mutual Fund. Nevertheless, such sanction could have a devastating effect on the commercial prospects of the Regulated Mutual Fund and its directors.
   
   Although DMS has continually supported a director disqualification regime, the Authority should take great care in wielding this power and there should be appropriate statutory checks and balances in place. We address these in section 3 below titled "Enforcement Action Must Not Offend the Constitution's Bill of Rights".

2. Broaden Scope.

1. Licenced Mutual Funds. The Guidance should apply to all Regulated Mutual Funds, i.e. registered, master, administered and licenced, without excluding the latter.
   
   
   1. The Authority proposes that the Guidance would apply to registered mutual funds (including master funds) and administered mutual funds and not to licenced mutual funds. The Authority's most recent statistics show 8,243 registered, 2,449 master, 400 administered and 117 licenced mutual funds.
   2. The Authority relied on a false premise – i.e. that Regulated Mutual Funds' deficient corporate governance was somehow responsible for the Global Banking Crisis of 2008 – for reforming corporate governance in the January Consultation with the inevitable result that the proposals were wholly inappropriate and irrational for Fund Governance.
   3. We do not see a good reason why directors of licenced mutual funds should be subject to different governance standards than directors of other Regulated Mutual Funds. Both administered and licenced mutual funds may be sold to "retail" investors and therefore they cannot be distinguished on that basis as justification for having different governance standards. Registered (including master) mutual funds and licenced mutual funds are not required to have a mutual fund administrator licence by the Authority and therefore they cannot be distinguished on that basis as justification for having different governance standards.
   4. The main premise for the Authority's January Consultation was the October 21st 2009 report by the Senior Supervisor Group ("SSG") to the Financial Stability Board of the Bank for International Settlements entitled "Risk Management Lessons From The Global Banking Crisis of 2008". The report was based on a survey of "twenty global financial institutions in our respective jurisdictions¹⁶ to assess during the first quarter of 2009 their risk management practices against a compilation of recommendations and observations drawn from several industry and supervisory studies published in 2008".
   5. The SSG stated, inter alia:
      
      
      "The events of 2007-09 underscored the vulnerabilities of those firms (i.e. global financial services organisations) whose business models were highly dependent on uninterrupted access to secured funding markets.
      
      Beginning in the summer of 2007 and continuing through 2009, lenders' willingness to finance less traditional, harder to price collateral diminished. In addition, counterparties and creditors sought to lessen their exposure to firms perceived to be "weaker" by reducing the amount of credit provided, increasing haircuts on positions financed and shortening the term for which credit was extended. Moreover, secured lenders tightened their definitions of acceptable collateral. These trends posed particular difficulties for firms that, lacking adequate liquidity reserves or contingent sources of funding, relied heavily on short-term repo funding collateralised by illiquid assets."
   6. That report clearly shows that the global banking crisis emanated from over-leveraged, under-regulated, systemically important banks in major onshore financial centres; those banks' hedge fund clients and counterparties were merely collateral damage. We submit that more onerous Fund Governance requirements – of the sort contemplated in the Proposed Measure – would have been and, if imposed would be, totally ineffective to insulate Regulated Mutual Funds from losses arising from contagion risks caused by systemically important banks.
2. Sole Corporate Director. The Guidance should reaffirm that a Regulated Mutual Fund may have a sole regulated corporate director which is an LMFA or wholly owned subsidiary thereof acting as a nominee of its parent. This is consistent with the Mutual Funds Law. It would be discriminatory and illegal to do otherwise.
   
   
   1. The UK has long recognised the concept of a sole corporate director. This is particularly so in the case of the authorised corporate director ("ACD") of an open-ended investment company ("OEIC")¹⁷, which is a well respected type of entity with a defined statutory function, analogous to an LMFA and used by leading fund sponsors worldwide. For example, JPMorgan Funds Limited is the ACD of JP Morgan Fund ICVC, an open-ended investment company registered in England and Wales¹⁸. JPMorgan Funds Limited is ultimately owned by JPMorgan Chase & Co., one of the largest banks in the world.
   2. On July 22nd 2013 the UK implemented the European Alternative Investment Managers Directive with The Alternative Investment Fund Managers Regulations 2013. The following provision¹⁹ shows that the sole corporate director continues to be recognised as a statutory entity in the new context of Alternative Investment Funds:
      
      
      "Open-Ended Investment Companies Regulations 2001 10. – (1) The Open-Ended Investment Companies Regulations 2001(b) are amended as follows
      
      (2) In regulation 15 (requirements for authorisation) –
      
      

      (a) for paragraph (6) substitute –
      
      

      "(6) If the company has only one director, that director must be a body corporate which is an authorised person and which has a Part 4A²⁰ permission to carry on the regulated activity of managing an UCITS or, as the case may be, managing an AIF.";..."
      
      
   3. The Authority apparently has an unwritten policy of insisting that every Regulated Mutual Fund must have at least two directors, one of whom must be an individual (i.e. natural person). We are aware of a least one instance where the Authority has previously refused to register a regulated mutual fund with a regulated corporate director as sole director and insisted on the appointment of at least one other director who is an individual. We also have evidence of the discriminatory application of this policy by the Authority in arbitrarily permitting some corporate directors while disallowing others with the same facts and circumstances.
   4. We consider that the Authority's said unwritten policy is unconstitutional. That is, it is not lawful, rational, proportionate and procedurally fair²¹. As noted above, the Authority's approach is seriously out of step with the UK's approach to the regulation of investment funds insofar as the Financial Conduct Authority will permit investment funds including both UCITS (i.e. retail) and AIFs (i.e. hedge funds), to have a sole corporate director. Stakeholders have been adversely affected by that policy and have the right to request and receive written reasons for that decision or act. This matter can be simply resolved by revising the Statement of Guidance for Regulated Mutual Funds as indicated in §9.1-§9.4 in Exhibit DMS1²²
   5. It is unclear why the Authority creates uncertainty about the ability of regulated corporate directors to serve Regulated Mutual Funds, since it is plainly provided for in the Mutual Funds Law and the Public Sector has relied on this provision in the Mutual Funds Law since 1993 with a legitimate expectation to continue such reliance. This decision of the Authority is inconsistent with established law and practice.
   6. We request that the Proposed Guidance be revised to expressly confirm that an LMFA may act as the sole director of a Regulated Mutual Fund. This is simply an institutional approach to the provision of fiduciary services and clearly permitted under the Mutual Funds Law since 1993.
   7. The Mutual Funds Law has always provided that:
      
      
      "'mutual fund administration', in respect of a mutual fund, means... to provide an operator to the mutual fund..."
      
      "operator", in respect of a mutual fund, means –
      
      

      (a) where the mutual fund is a unit trust, a trustee of that trust;
      
      (b) where the mutual fund is a partnership, a general partner in that partnership; or
      
      (c) where the mutual fund is a company, a director of that company²³ ;"
      
      
   8. Since at least 2005, the Authority has recognised that a licenced mutual fund administrator may provide a sole corporate director to a licenced mutual fund²⁴
      
      
      "Unless a corporate director is appointed, a minimum of two individuals must be named as directors of all funds. In the case of corporate directors, one director is acceptable if that corporation is licenced by the Authority or is otherwise acceptable to the Authority and a current register of directors should be filed with the licence application. Any change in directors must be approved by the Authority."
   9. It follows that there should be no doubt that the LMFA may provide itself as a Regulated Mutual Fund's sole operator, whether that is a director, general partner or, if the LMFA is a licenced trust company, trustee of a company, limited partnership or unit trust, as the case may be. The Authority already requires all LMFAs to have at least two directors²⁵.
   10. An LMFA is licenced to act as the investment manager or administrator of a Regulated Mutual Fund. When an LMFA acts in either of those capacities, the Authority does not require a second person to share the same responsibility; yet a Regulated Mutual Fund is more vulnerable to wrongdoing or errors by an investment manager or administrator because they directly control the Regulated Mutual Fund's assets and most of its liabilities.
   11. The Authority does not require two separate persons to fulfill any other discrete function to a Regulated Mutual Fund, such as investment manager, share registrar, auditor or law firm. In fact, the Authority will not question an LMFA's appointment as sole investment manager or share registrar of a Regulated Mutual Fund in the absence of some regulatory infraction by the LMFA.
   12. If the LMFA is also a licenced trust company, it may act as sole trustee, i.e. operator, of a unit trust that is a Regulated Mutual Fund or sole director of a licenced mutual fund. It is irrational to prohibit that LMFA also acting as sole director, i.e. operator, of a company that is any other type of Regulated Mutual Fund, i.e. registered, master or administered.

3. Enforcement Action Must Not Offend the Constitution's Bill of Rights.

1. The Authority must take great caution and care in crafting the Proposed Measure for three reasons.
2. First, the Authority has statutory duties to ensure that any burden or restriction imposed by the Proposed Measure is in the best economic interests of the Cayman Islands²⁶ and is competitive²⁷, relevant and appropriate²⁸ and proportionate²⁹.
3. Second, the Authority intends to rely on breach of the governance standards in the Proposed Measure³⁰ as justification to take enforcement action against a Regulated Mutual Fund, its promoter and/or any director³¹.
4. Third, the Bill of Rights in the Cayman Islands Constitution provides, inter alia ; this could cause any one of them irreversible reputational and financial losses.³²
   
   
   "Lawful administrative action :
   
   19. – (1) All decisions and acts of public officials must be lawful, rational, proportionate and procedurally fair.
   
   (2) Every person whose interests have been adversely affected by such a decision or act has the right to request and be given written reasons for that decision or act."
5. There is no doubt that certain people should not be trusted to manage or oversee the management of other people's money. This may be due to their lack of relevant experience or their track record as a "bad actor". However, it is a basic principle of natural justice and the rule of law in these Islands that everyone should have the right to a fair hearing and this should certainly be the case when any individual's livelihood is at stake.
6. The Authority should not take any enforcement action against a director for alleged infraction of the Guidance before there is an appropriate statutory mechanism for a fair hearing.
7. That is, the Mutual Funds Law should be amended to ensure that there is a complaints procedure which can be referred to an impartial disciplinary tribunal which would afford the parties the right to a fair hearing with the right of appeal to the Grand Court – Financial Services Division³³.

4. The only statutory right of appeal to the Grand Court against the Authority's decisions³⁴ is that of Licenced Mutual Funds³⁵ or Licenced Mutual Fund Administrators³⁶ which have had their licences revoked. As mentioned above, the Authority's Proposed Measure would significantly broaden the scope of its statutory enforcement – against Directors and others considered to be in breach of the new governance standards. This should be balanced by providing a statutory right of appeal to anyone aggrieved by the Authority's enforcement actions taken pursuant to the Proposed Measure. The appeal should be handled administratively by a tribunal in the first instance, rather than by the Grand Court. However, even a direct appeal to the Grand Court would be preferable to judicial review, the only existing common law alternative, because such an application requires leave of the Court and must be made within three months of the Authority's decision³⁷.

5. Accordingly, we request that the Authority not proceed with the Proposed Measure until the Mutual Funds Law is amended to provide aggrieved persons with the right to appeal any enforcement action for alleged breach of the Proposed Measure to an appropriate statutory tribunal and with the right of further appeal from the tribunal to the Grand Court. We consider that failure to provide such an appeal mechanism would be inconsistent with principles of natural justice.

Conclusion

In conclusion, we request the Authority to revise the Guidance to reflect the appropriate and rational expectations of all stakeholders. In summary, the Guidance should be consistent with a director's fiduciary duties at common law and not attempt to impose inappropriate burdens, risks and costs on Regulated Mutual Funds and their directors, particularly obligations that have been appropriately delegated to the investment manager, administrator or other service providers. DMS's revisions in Exhibit DMS1 should achieve that objective for the reasons provided therein. The Guidance should apply equally to all Regulated Mutual Funds, whether registered, master, administered or licenced; the latter should not also be subject to a different Statement of Guidance on Corporate Governance. The Guidance should reaffirm the use of a sole corporate director that is a licenced mutual fund administrator or wholly owned subsidiary thereof. The Mutual Funds Law should be amended to provide a new statutory appeal mechanism available to directors and operators who are the subject of complaints and/or enforcement action in accordance with the Bill of Rights.

Please contact me if you have any questions regarding DMS's responses to the July Consultation or Guidance. We look forward to your reply and confirm that we are fully reserving our rights in every regard.

Yours sincerely,

Don Seymour
Managing Director

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Footnotes

1 http://www.cimoney.com.ky/regulatory_framework/reg_frame.aspx?id=360

2 http://www.cimoney.com.ky/Stats_Reg_Ent/stats_reg_ent.aspx?id=256&ekmensel=e2f22c9a_14_84_256_6

3 Bloomberg-Schumer report and other similar reports.

4 The US Investment Company Act of 1940 created the "four pillars of protection" for mutual fund investors. These protections give investors confidence that:

5 Reporting by Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors on Form PF. Joint final rules by CFTC and SEC. dated October 31, 2011. http://www.sec.gov/rules/final/2011/ia-3308.pdf

6 The NED, May 2013

7 http://www.judicial.ky/CILRSearch/index.php

8 http://cimoney.com.ky/search/searchforentity.aspx?searchtext=

9 http://www.iosco.org/library/pubdocs/pdf/IOSCOPD359.pdf. See in particular Principle 28 on pages 167 to 176.

10 Paragraph 19 on page 5 of the July Consultation states:

11 See paragraph 19 on page 5 of the July Consultation. The July Consultation introduces responsibilities, and therefore liabilities, on hedge fund directors. However, it appears that Principle 28 in the IOSCO paper relates almost exclusively to hedge fund managers/advisers, not to hedge fund directors.

12 "Key Questions" on pages 170 to 176 in this document: http://www.iosco.org/library/pubdocs/pdf/IOSCOPD359.pdf

13 Mutual Funds Law (2012 Revision), §30 – Powers of Authority in respect of regulated mutual funds.

14 Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers, Recital 21 http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2011:174:0001:01:EN:PDF

15 2011 CIMA Investment Statistical Digest showing total industry assets of $1.8 trillion and 86% of funds having a minimum investment of $1m or less.

16 The Senior Supervisors Group comprised representatives of six countries' top financial services regulators, namely: Canada's Office of Superintendent of Financial Institutions, France's Banking Commission, Germany's Federal Financial Supervisory Authority, Japan's Financial Services Authority, Switzerland's Financial Market Supervisory Authority, United Kingdom's Financial Services Authority and United States' Federal Reserve, Comptroller of the Currency and Securities and Exchange Commission.

17 Open-Ended Investment Companies Regulations 2001, §15(6):

18 Prospectus of JPMorgan Fund ICVC effective from July 29th 2013. http://am.jpmorgan.co.uk/adviser/_documents/jpmorgan-fund-icvc-pro-gb-en-29-07-13-with-05-08-13-insert.pdf

19 The Alternative Investment Fund Managers Regulations 2013, Schedule 1 – Amendments to Preliminary Legislation, Part 1 – Amendments to the Financial Services and Markets Act 2000.

20 Financial Services Act 2012, PART 2, Permission to carry on regulated activities, §11. http://www.legislation.gov.uk/ukpga/2012/21/section/11

21 The Cayman Islands Constitution Order 2009, Bill of Rights, §19. http://www.constitution.gov.ky/pls/portal/docs/PAGE/CRSHOME/CONSTITUTION/2009%20CONSTITUTION%20ORDER.PDF

22 Statement of Guidance – Licensing Mutual Funds, §3.1. http://www.cimoney.com.ky/regulatory_framework/reg_frame.aspx?id=366

23 Mutual Funds Law (2012 Revision), §2

25 A licenced mutual fund administrator that is a company shall, at all times, have at least two directors. A person who contravenes this provision commits an offence and is liable on conviction to a fine of CI$20,000. Mutual Funds Law (2012 Revision), §22.

26 Monetary Authority Law (2011 Revision), §6(2)(a)

27 Ibid., §6(3)(c)

28 Ibid., §6(3)(c)

29 Ibid., §6(3)(d)

30 §3.1, SoG-MF

31 Mutual Funds Law (2012 Revision) (as amended), §30(3). Enforcement powers include requiring substitution of any promoter or director, cancellation of the mutual fund's registration and appointment of a person to advise the fund on the proper conduct of its affairs to assume control of its affairs.

32 The Cayman Islands Constitution Order 2009. http://www.constitution.gov.ky/pls/portal/docs/PAGE/CRSHOME/CONSTITUTION/2009%20CONSTITUTION%20ORDER.PDF

33 For example, see The Legal Practitioners Bill, 2012, PART 6- DISCIPLINE WITHIN THE LEGAL PROFESSION: http://www.gov.ky/pls/portal/docs/PAGE/CIGHOME/FIND/ORGANISATIONS/AZAGENCIES/LGB/DOCUMENTS/LEGAL%20PRACTITIONERS%20BILL%202012%20NOVEMBER%2025TH%20CONSULTATION%20DISCUSSION%20DRAFT.PDF

34 Mutual Funds Law (2012 Revision) (as amended), §36(1).

35 Ibid., §30(3)(a) or (15).

36 Ibid., §31(3)(a) or (12).

37 Grand Court Rules 1995 (Revised Edition), Order 53, rule 1.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.