While standard governance principles continue to apply (and should be followed) throughout the lifetime of a fund, the board of directors must be prepared to adapt governance practices and, for example, revisit discussions with service providers. In the event of market disruption, where risk levels invariably increase and additional reporting and discussion is merited, new or additional practices may need to be adopted to ensure effective oversight of the fund and its service providers.

For example, when the markets are turbulent and/or disrupted, it may be difficult for the investment manager to manage the fund in accordance with the fund's defined investment criteria, investment strategy and restrictions (although market disruption may of course also create opportunities for the investment manager). The directors should proactively enquire about this, and ensure that service providers have an effective system of control to mitigate risks to achieving the investment objective (including control over technology used). In the face of potential distress, it is particularly important to ensure that a service provider's infrastructure will cope with evolving trading practices whilst remaining within set investment parameters.

The calculation of NAV may also be more involved if any of the assets in the fund's portfolio become hard-to-value, e.g. because there is no directly observable market price for such assets, perhaps as a result of sanctions. Recently, the imposition of global sanctions (not just related to the Russian invasion of Ukraine) has presented challenges of this nature, and there has been a need for proactive engagement by directors to ensure compliance by service providers with applicable law. Furthermore, the use of leverage may heighten insolvency risk and liquidity issues may result in an inability to meet redemptions.

Accordingly, during a period of market disruption and/or turbulence, ad hoc or more regular meetings of the board of directors may be appropriate to enable the directors to fulfil their responsibilities. In particular, the directors should increase reporting from:

1. the investment manager, e.g. as regards the liquidity profile of the fund, use of leverage and any departures from the investment criteria, investment strategy and restrictions. In a period of market turbulence, a continued understanding of the financial position of the fund, risk and robustness of controls adopted by service providers is key – the directors must ensure they are fully cognisant of the fund's risks and such risks are always appropriately managed and mitigated, with material risks being discussed at the board meeting and the board of directors taking appropriate action where necessary; and

2. the administrator, e.g. it will be important to understand whether any redemption requests have been submitted and, if necessary, whether the investment manager can manage the sale of the fund's assets to satisfy such requests while protecting value for the remaining investors.

In addition, a thorough analysis of the assets constituting the fund's portfolio should be undertaken and reports should be provided to the board of directors as regards the calculation of NAV, including any deviations from the fund's calculation policy and/or where market prices are unavailable and asset values have been determined by, or in consultation with, the investment manager. Ultimately, the board of directors must ensure that NAV is fair, complete, neutral and free from material error and is verifiable.

Separately, it would be advisable for the directors, with a clear understanding of the broader factual matrix, to engage with legal counsel and audit the key terms of the constitutional documents of the fund, the offering memorandum, subscription agreement, any side letter arrangements, service provider agreements and the details of any credit facilities. Legal counsel will then be able to advise the board of directors on, for example:

  • the range of defensive measures available to the fund to provide stability, should the fund become distressed, e.g. redemption gates, side pockets, suspensions, redemption in-specie, restructuring and synthetic side pockets;
  • any considerations and/or risks associated with any preferential terms granted to investors further to any side letter arrangements. For instance, certain terms relating to liquidity or the exercise of the directors' discretion may be problematic or make a particular defensive measure more involved; and
  • whether a potential defensive measure (which may include a regulatory filing) may trigger an event-of-default or other obligation on the fund by reference to credit facility documentation or other agreement with a third party.

Crucially, any proposed solution must fall within the parameters of the fund's governing documents and the broader contractual arrangements the fund has entered into, failing which it is vital for the directors to understand the risks associated with any particular course of action (and how best to mitigate those risks). Ultimately, it is important for the board of directors to probe the preparedness of service providers and be poised to act, given how rapidly events can unfold in a distressed situation: the appropriate solution to manage the fund through its difficulties will always depend on the internal controls employed by service providers, the commercial circumstances at the time (including discussions with investors and, possibly, creditors) and the desired outcome.

If a fund becomes distressed and liquidity issues arise, an emergency meeting of the board of directors will almost certainly be required. While the constitutional documents of most modern funds permit ad hoc meetings at short notice and by telephone/video conference, the constitutional documents will still need to be checked to ensure any stipulated requirements relating to the holding of board meetings, e.g. the requirement for prior notice (including the ability to waive notice and any other formalities), are satisfied.

In addition, depending on the circumstances, the location of the directors may make attendance difficult (in light of current restrictions/limitations on travels), e.g. in the event the location of a director has adverse consequences on the fund from a non-Cayman legal/tax perspective. It will be important to engage relevant local (tax) counsel on this issue.

Assuming the board of directors is able to validly meet, at the outset of the meeting it will be essential for the board of directors to:

  • manage conflicts of interest. For example, if a real (or ostensible) conflict arises, a director may wish to recuse themselves from relevant discussions and/or resolutions, or even step-down as a director to ensure the integrity of the board is not, in any way, compromised. In particular, if the investment manager is represented on the board of directors (which is typical), then conflicts as regards "their" director may quickly become apparent, e.g. in the context of discussions around NAV calculation/hard-to-value assets and fee terms. Whilst CIMA has acknowledged that directors of the fund may also be members of the investment manager and its group, the directors have, amongst others, a duty to avoid conflicts of interest and a duty to act in what the director bona fide considers to be in the best interests of the fund. It is therefore imperative that any conflicts of interest are suitably identified, disclosed, monitored and managed. Any conflicts of interest should be noted in the board minutes (or documented in written resolutions);
  • establish if the fund is insolvent or 'in zone of insolvency', i.e. is the fund able to pay its debts as they fall due (including any crystallised redemption payments). This analysis will also include any debts which are prospective in nature1. This is because, where the fund is insolvent, the directors must have regard to the interests of the fund's creditors when discharging their duties to the fund, rather than (in a solvent situation) having regard to the interests of the fund and investors as a whole. The fund's financial position needs to be verified by the board of directors undertaking a full assessment of the fund's financial position and consistently with the valuation of assets principles discussed above. Such cash flow assessment should be undertaken regularly by the fund to allow the board of directors to make appropriate decisions; and
  • consider whether they have sufficient and relevant knowledge and experience to carry out their duties as directors in a distressed situation. It might be the case that the appointment of additional or replacement directors who specialise in distressed situations is appropriate.

Once these basic, but essential, issues have been addressed, the board of directors may then seek to manage liquidity in consultation with the investment manager.

In doing so, it is strongly recommended that the board of directors consults with its legal counsel (and, in particular, insolvency and dispute resolution teams), as, amongst other matters, there can be significant personal implications on the directors and it may be necessary to communicate with regulators.

In particular, the law in this area often evolves quickly and there are restructuring tools available to funds in the Cayman Islands that can facilitate a restructuring of the fund whilst providing a 'safe harbour' for the directors and a stay on claims against the fund.

However, it may be the case that certain discussions between the board of directors and legal counsel take place independently; that is, away from the investment manager, in light of the potential conflicts of interest that may arise in a distressed situation.

As ever, detailed minutes of all meetings, including the matters considered and decisions made, and the information requested from, and provided by, service providers (including, in particular, with regard to the effectiveness of the internal controls implemented by the service provider and the ability of their infrastructure to withstand the situation) and advisors, should then be prepared for the review and sign-off by the directors. Where permitted, a meeting accompanied by detailed written resolutions may be preferable.

It is always possible that the resolutions of the board of directors could be scrutinised at a later date, and accurate record-keeping may assist the directors in demonstrating that they discharged their duties as directors.

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.