We are often asked by potential clients, investors and even competitors why someone would require an independent service provider to support the operational delivery and/or governance of an offshore fund structure. The key reasons centre round good corporate governance and the importance of ensuring independence.
Awareness of the importance of good corporate governance has been gaining momentum since the commencement of the financial crisis in 2008, with Japanese investors becoming increasingly conscious of their monitoring capabilities and the ever-changing regulatory landscape.
Recently, the Financial Services Agency in Japan has released a consultation paper, which is widely believed to be the basis of their upcoming guidelines, specifically related to fee transparency and corporate governance. The asset management companies that create investment trusts and other products are often affiliated with the large financial groups, and the new guidelines would require these financial institutions to draw up specific policies for managing such conflicts of interest and make them publicly available. In addition, there has been a surge in policy initiatives to strengthen corporate governance frameworks and transparency of investor reporting including changes to EU regulation (AIFMD), FATCA and Common Reporting Standards.
As the requirements of governance standards come under greater scrutiny, more parties are becoming involved in the good governance of a fund, with investors, service providers and regulators all taking a greater interest in how a fund exercises proper control. The independence that an offshore fund services provider can offer, including its ability to procure and work with independent directors, is becoming increasingly important to investors.
If a service provider is affiliated with a financial institution (that is integral to the structure), a significant conflict of interest may arise which could prove difficult to overcome. An independent service provider can avoid these potential conflicts of interest and present a simpler option when dealing with contentious matters if and when they arise, notwithstanding changes in regulation, restructuring or interpretation of statutory documentation.
Historically, as long as the fund performance was acceptable, corporate governance was not regarded as a critical element within the structure. However, major scandals over the last decade have highlighted the need for strong corporate governance.
For example, a watershed case for many professionals in the fund industry was the Cayman Weavering case in 2009, which measured the liability of directors and sent shockwaves through funds industry in the offshore world. The directors of the Weavering Macro Fixed Income Fund were found to be personally liable for redemption excesses of $111 million following the discovery that most of the assets on its balance sheet were fictitious. The fund subsequently went into liquidation with losses of more than $500 million. The case highlighted the high level of responsibility of each director of a fund and the importance of an independent service provider.
The Bernard Madoff case, considered the biggest scandal in hedge fund history, was famously due to Madoff having undue control over the pricing and governance of the fund’s assets, with an estimated $50 billion in losses for investors. Cases such as these have rocked the investment world and driven investors to demand greater due diligence and transparency.
Significant time and effort is often spent establishing an offshore entity. Perhaps however, on occasion, too little time and effort is spent ensuring that the activities of the structure remain offshore and therefore fall outside of the tax framework of the onshore entity.
The level of ‘substance’ and where ‘management and control’ is conducted are the general approaches employed by tax authorities when considering whether to classify an entity as ‘offshore’ or whether an entity is in fact regarded as ‘onshore’ for tax purposes (despite being established offshore).
An independent service provider is often one of the key elements to help ensure independence and will provide a number of services to support this aim, such as providing offshore resident directors and ensuring meetings are held offshore – thereby allowing the structure to clearly demonstrate that management and control is conducted in the jurisdiction of the offshore entity.
It is also important to ensure that sufficient numbers of the directors are operating independently, with investors and regulators alike scrutinizing board actions more closely. Independence is characterised by the lack of any links to the companies in which the fund invests, or to significant service providers to the fund.
Ultimately, the need to have an experienced, trusted independent service provider is no longer a ‘nice to have’ but a crucial element of a structure to protect stakeholder interests and deal with the burgeoning requirements of compliance and regulation. And as several high-profile cases have shown, the most important mistake to avoid is complacency.