Stakeholder Attitudes

The sound of the bubble bursting is not offshore

Originally published in the October 2010 issue

Every corporate/hedge fund blow up and financial crisis is transformed into a sensational media circus. Offshore financial centres frequently appear as the main exhibit, regardless of the root of the problem.

Infamous scandals over the years include Worldcom, Long-Term Capital Management, Enron and Weavering Capital. Without the media’s colourful headlines, attention would be focused on the real, material issue surrounding these cases: poor corporate governance. In any geographical location, this can lead to:

• bad management and oversight;
• poor policies and procedures, including internal controls;
• breakdown of independence, either between external auditors and the company or the board of directors and other stakeholders;
• conflicts of interest;
• fraud;
• massive shareholder losses

It must be appreciated that these types of problems are deeply rooted in stakeholders’ attitudes. With this newinsight, it will be seen that there is no causal link between these matters and offshore jurisdictions. The media spotlight ought to return where it belongs: onshore.

Onshore: poor corporate governance
It is important that the media makes onshore stakeholders accountable. This should deter them from engagement in harmful practices in the future and create an environment for better corporate governance.

Before talking about making it better though, it may be good to provide a definition of the concept. Wikipedia defines corporate governance as a “set of processes, customs, policies, laws, and institutions affecting the way a corporation (or company) is directed, administered or controlled. Corporate governance also includes the relationships among the many stakeholders involved and the goals for which the corporation is governed”. In a hedge fund context, the principal stakeholders would be the shareholders, the board of directors (and the service providers to whom they delegate functions), and, perhaps, members of the financial services industry at large.

Taking a look at the above definition, one can see that, if left unchecked for a significant period of time, corporate governance practices can quickly go from bad to worse. This is especially true where a board of directors is indifferent to its oversight responsibility in the case of delegated functions to investment managers and administrators. Unmonitored, some managers may go on a frolic of their own: failing to invest subscription monies and using the same to buy Ferraris and multiple homes, while at the same time falsifying broker and custodian statements and NAV reports to give shareholders the impression that the fund is performing well. Therefore, shareholders must check (not assume) that their company’s board of directors has strict corporate governance practices in place.

It would be a shame if it was discovered that a board is not actually acting in the best interests of the company and is, instead, only a figurehead for the investment manager. A board member might have this mindset (and blindly ratify an investment manager’s actions) because the investment manager is the party that initially secured the board member’s appointment and he is relying on the investment manager to procure the payment of director fees. This is an example of poor practice. The proper course of action may be to replace the offending board member. Failing to do this will lead to a corporate governance disaster.

Onshore: how many of the parties are located there?
While the domicile of a problem fund might be offshore or even if one of its directors may be located there, the media rarely draws attention to the fact that many of the parties involved in a scandal have their full scale of operations onshore. As mentioned above, these parties include the investment manager and administrator. Other responsible players are the custodian, prime broker and external auditors.

Sometimes, these parties mislead those involved offshore or misuse the jurisdiction. It is the kind of thing that cannot be detected by a due diligence check, but perhaps it could be avoided if stakeholders started choosing more service providers offshore, where the hedge funds are domiciled. For example, the Cayman Islands are the world’s leading jurisdiction and service providers who do not currently have a presence should consider moving their operations there in order to be closer to the fund.

Onshore: what is being done to stop the bubble from bursting?
A myriad of new laws, regulations and directives have been implemented in Europe, North America and other countries. In the media reports, it is said that the purpose of such actions is to increase investor protection, create a stable financial system and help manage systemic risk. The media would like investors to accept this message, with the hope that it will increase confidence in the financial markets and help to remove some investment fears. However, what is being hidden is the truth: nothing has actually changed.

For example, one can look at the reported aims of new global initiatives and ask how investors have been magically protected and economies become safe during the period from the passing of legislation to the full implementation of regulations dealing with the same. Will investors get an email when industry watchdogs are deployed? Will some tool be created for the purpose of identifying with precision when the market is about to burst? How would one know these things for sure or be certain that the answer for one segment will not inadvertently lead to problems in another area?

It is clear that the parties implementing these measures need years to understand the complexities of the bureaucratic structures they have created. Further years may be required in order to observe results. In the meantime, it seems that the financial system and structures in onshore jurisdictions continue to be at risk. No real change will happen overnight. Therefore, all efforts must start with an adjustment to stakeholders’ attitudes.

It is up to the directors of an entity to perform their oversight function and to ensure that all is kosher. Shareholders also play a role in that they must pay attention to the persons being appointed to the board of directors in the first place and ensure that they are reporting to stakeholders on a periodic basis, holding management accountable for all of their actions and inactions. When things go wrong, responsible parties must not be permitted to run away from the real issues. The media points its finger offshore because, presumably, any link to an offshore component results in a more sensational, exotic news piece and higher ratings. Hopefully, the general public will soon see the media portrayal of offshore jurisdictions for what it is – a distraction from problems which may have evolved from ideas crafted onshore. Only when attention is focused on this fact will the “evil offshore” depiction be permanently binned and the media circus taken off the road.

Alric Lindsay is a non-executive director to Cayman Islands based investment vehicles and an attorney at large. He is a former attorney with Maples and Calder and Ogier. He has also worked as a senior compliance analyst with the Cayman Islands Monetary Authority.