Role playing

Investors need to wake up to the legal complexities pertaining to the precise nature of their law firms’ involvement in fund structures. By Nick Holland

Most lawyers attempt to avoid or at least ­minimise conflicting roles as much as possible, and are usually required by their regulatory authorities to do so. For this reason, the many conflicting roles in ­offshore investment structures played by organisations related to some offshore law firms are, at first blush, ­puzzling in their disregard for this approach and arguably in their fiduciary obligations to their clients.

The following is a common example of a hedge fund structure, which will usually be tax-driven. The firm will, at the behest of an investment manager, create a ’master fund’ company: the management’s shares in the master fund company will be owned by another company owned by the partners of the same law firm (Law Firm Co); the non-voting shares will be owned by two feeder fund entities (one designed for US taxable investors, the other for non-US taxable investors). Law Firm Co will hold the ­management shares in the master fund in trust for the purpose of holding the shares; the enforcer/protector of this trust will often be a party related to the law firm as well. Law Firm Co will, as the sole voting shareholder in Master Fund Co, appoint its own high-ranking officers/directors to act as the majority of the board of directors of the master fund. These same directors will then appoint the law firm to act as lawyers to the master fund. The feeder funds will ­essentially have the same structure, except that the non-voting shareholders will be the investors.

Essentially, the law firm and its related entities will receive fees as lawyers to the fund during its establishment, trustee fees, protector/enforcer fees, director fees and legal fees throughout the existence of the fund at both the master fund and feeder fund levels. Furthermore, the law firm and its related entities can only be removed from the fund structure with the consent of one of the law firm-related parties, unless the fund is placed in liquidation – although even that remedy may be difficult to obtain or ­unavailable (for example, it is now possible under Cayman Islands law to incorporate a company that cannot be placed in ­liquidation without the consent of its ­directors).

The million-dollar question

The question, then, is how could it possibly be in the interests of the fund companies or the investors to have a structure whereby one law firm is irrevocably ensconced in so many different roles and drawing so many different fees?

However, it could be argued that this is entirely the wrong question from the law firm’s perspective.

The issue the law firm is retained to resolve when the fund is structured is: how irrevocably to ensconce the investment manager in the structure, regardless of the possible changing wishes of the investors and fund companies.

The law firm’s answer to the problem is often to place itself and its related entities in the sole position that is permitted to appoint the investment manager, thereby protecting its client, the investment manager. Some of these roles are in reality figurehead ­positions: the management shareholders are supposed to leave much of the business to the directors, and the directors delegate virtually all of their responsibilities to other entities. However, there are serious ­exceptions to the first statement, and the legal effect of the second statement is very much open to question.

The plot thickens

The investors probably never turned their minds to these legal niceties (some will have known they had few legal rights; others will have assumed wrongly that they possess protections they may not ultimately have) until the fund has suspended its net asset value or its redemptions. Now they care a lot, and investors are beating down the doors of the financial advisers and ­investment managers who put them into these funds.

Certainly these conflicting roles do not read well. This is, in part, the problem. Some firms have prepared offer documents for certain funds that do not set out ­adequately or accurately these conflicts and the descriptions of these various entities; and their relationships to one another are often ­drafted to read as a glossy sales pitch rather than a legally obliged disclosure. The ­ramifications of these conflicts in the more extreme examples are very rarely, if ever, set out in their harsh black-and-white ­reality.

Structural integrity

There are arguments in support of such structures that can be, and often are, made.

The fund is only a vehicle for investment. The investment manager and the investors are not looking for legally enforceable rights in respect of their investment – they only want a good rate of return. If the lawyers are not ensconced, the investment manager is not inviolable, and the investors wish to avoid any risk of the investment manager being removed. Not all conflicts are ­necessarily regarded as being grounds for a claim and, ultimately, only a court can decide on the relative merits of any ­particular case.

But that is precisely the point. A very small number of disputes arising out of some of these conflicts are already the subject of legal proceedings, but very soon the investors, the independent financial advisers who placed them in these funds and, indeed, even the investment managers on whose behalf these structures were constructed are likely to ­subject the merits of these structures to the scrutiny of the courts, especially in cases involving inadequate disclosure of the ­conflicts in the offer documents.

The question then will turn on whether the courts treat these conflicts as so much interesting topiary or a matter of material concern.

Nick Holland is head of contentious trusts and estates at Bircham Dyson Bell