The recent spectacular corporate collapses of Enron, WorldCom and Tyco in the United States, Parlamat in Europe and HIH in Australia have wiped out billions of dollars of shareholder funds and have exposed serious shortcomings in corporate governance - the system by which companies are directed and managed.
We have had scandal rocking the U.S. onshore mutual fund industry since the New York State attorney general first charged the Canary Capital Partners hedge fund with improper trading in mutual funds which then embroiled well known fund groups such as Putnam, Strong, Janus and Alliance Capital.
Since these scandals have erupted, governments have introduced reforms for publicly held companies and stock exchanges have introduced new rules and regulations and corporate governance guidelines.
In the hedge fund world we have seen the implosion of the Manhattan Fund and more recently the Lancer funds.
The scandals have shown a serious lack of effective oversight of corporate accounting and financial reporting and a lack in managing conflicts of interest.
The U.S. Securities and Exchange Commission is increasing its regulation of onshore mutual funds and is considering some form of regulation of hedge funds. The offshore hedge funds industry must consider evolving with these developments - investors will require it.
A common theme of new reforms is the substantial enhancement of the independence and responsibilities of boards of directors.
What is a Director
The role was invented centuries ago, dating at least since the establishment of the Dutch East India Company in 1602.
The basic function of directors is to oversee the affairs and activities of the company. The company is a legal person - it has shareholders who legally own the enterprise. It has an elected committee (known as the board of directors) who exercise delegated authority (as agents of the shareholders) to manage the enterprise in accordance with formal rules, specifically the memorandum and articles of association (or constitution) but also the provisions of company and other laws in the jurisdiction in which it is established).
These rules vest the power to control and manage the company's property and affairs in the board of directors. The director's central mission is to be diligent in representing the interest of shareholders.
Non-Executive versus Executive / Independent versus Interested
Executive directors are full-time employees involved in the day-to-day management of the company. Non-executive directors have a part-time and intermittent involvement with the company.
There is however no legal distinction between executive and non-executive directors. Non-executive directors have the same legal duties, responsibilities and potential liabilities as their executive counterparts.
An "independent" director is one who is independent of management and free from any business or other relationships which could significantly interfere with the director's ability to act with a view to the best interests of the company.
The Fund Model
Like any corporation, an investment fund organised as a company has a board of directors to oversee the operation of the business and to ensure that its corporate policies are followed.
However a fund does not normally have employees of its own. Its operations are typically conducted by enterprises hired by the fund. The fund's property, or investment portfolio, is managed by an investment manager or adviser. A custodian holds the assets, maintaining them separately to protect the shareholders interests. It may have a prime broker through whom trades are executed, either directly or indirectly, and financing and leverage facilities are made available. It will have an administrator who maintains the books of account and produces the net asset value calculations. It will have a registrar or transfer agent who processes all orders to buy and sell the fund's shares and maintain its register of shareholders and it may have a distributor or placement agent or sponsor who will promote and sell the shares to its clients. It will also appoint outside law firms (both lead and jurisdictional) to provide legal services to the fund. The fund, through its board of directors, is responsible for negotiating and overseeing contracts with each of these enterprises who provide services to the fund.
Under this structure it can be seen that the interests of the fund and its shareholders differ from the interests of its investment adviser or management company.
Directors of investment funds are either "interested" or "independent". Interested directors are employees of the fund's investment manager. Independent directors in contrast will not have any significant relationship with the fund's manager, and I would suggest, its other service providers.
Duties of Directors
Whether executive or non-executive, independent or interested, all directors have the same duties.
Let's take the laws of the Cayman Islands as an example as it is one of the most popular jurisdictions in which to establish an offshore hedge fund. The company law in the Caymans essentially imports the principles of English common law - common law being the body of precedent developed as judges interpret previous cases.
In the Cayman Islands (as well as other common law jurisdictions) the duties of a director fall into two broad groups:
- the duties of loyalty, honesty and good faith (or "fiduciary" duties), and
- the duties of care, skill and diligence.
These duties exist in law to protect shareholders from the risk of directors causing harm to the company or its assets. The risk arises because the internal rules of most companies vest the power to control and manage the company's property and affairs in the board of directors. Shareholders are vulnerable to harms such as:
- fraud - directors taking assets, opportunities or information belonging to the company and using it for their own personal advantage, and
- mismanagement - directors risking loss or devaluation of the company's assets through incompetence and poor decision making.
Directors owe duties of good faith and loyalty because they are in a "fiduciary relationship", not unlike (but less than) what is owed by a trustee to beneficiaries or unitholders. Fiduciary relations revolve around the concept of trust and confidence - a fiduciary is expected to put the interests of those he is acting for (that is the fund's shareholders) ahead of his own, to avoid any semblance of conflict of interest.
A Code of Conduct
These duties under law, taken together with principles of good corporate governance as imposed or recommended by regulatory authorities, and expected by prudent investors, could be translated in practice to derive at the following fund director's code of conduct (which I have based on that expected of members, of whom I am one, of the Australian Institute of Company Directors):
- A fund director must act honestly, in good faith and in the best interest of the fund as a whole.
- A director has a duty to use due care and diligence in fulfilling the functions of office and exercising all the powers attached to that office.
- A director must use the powers of office for a proper purpose, in the best interests of the fund as a whole.
- A director must recognise that the primary responsibility is to the fund's shareholders as a whole but should, where appropriate, have regard for the interests of other fund stakeholders (such as creditors).
- A director should seek to ensure that all shareholders or classes of shareholders are treated fairly and equally according to their rights as between each other (as laid down in the fund's articles).
- A director must not make improper use of information acquired as a director.
- A director must not take improper advantage of his position of director. In particular he must not trade in a listed fund's shares while in possession of information which, if publicly disclosed, would be likely to materially affect the price of the fund's shares.
- A director must not allow personal interests, or the interests of any associated person such as a family member, to conflict with the interests of the fund. Full disclosure of any conflict or potential conflict, must be made to the board of directors.
- A director has an obligation to be independent in judgment and actions and to take all reasonable steps to be satisfied as to the soundness of all decisions taken by the board of directors.
- Confidential information received by a director in the course of the exercise of his duties remains the property of the fund and it is improper to disclose it, or allow it to be disclosed, unless that disclosure has been authorised by the fund, or is required by law.
- A director should not engage in conduct likely to bring discredit upon the fund.
- A director should have an obligation not only to comply with the letter of the law but as well the spirit of the law, and with principles of good corporate governance. He should endeavour to ensure that the fund strives for the highest standards of business and ethical conduct.
Rights of Directors
So a director has certain wide-ranging responsibilities and duties. But does he have rights?
Directors are appointed by shareholders who vest the directors with significant power to oversee the affairs of the fund company on their behalf. He is in effect an agent of the company.
Just as a director has been vested, or delegated, powers by the shareholders, directors (usually through the fund's articles of association) may delegate or appoint other agents on their behalf. This is particularly relevant to investment funds where the directors will appoint service providers to the fund, including an investment manager, an administrator, custodian, registrar and transfer agent and a prime broker.
Contracts will be entered into with these "delegates" and once negotiated and concluded, the directors will be responsible for monitoring the delegates' performance in accordance with the terms of those contracts.
The fund's articles will allow the delegates, including the directors, to be indemnified from liability to some extent, but not naturally for fraud and dishonesty.
Directors also have a right to receive information about the fund's affairs, and this generally will be enshrined in the fund's articles.
Information Needs and the Role of Directors
Independent directors can only be valuable to the funds they serve if the fund (particularly through its sponsor and investment manager) takes seriously its responsibilities to provide appropriate, useful and timely information.
So what information does a fund director require in order to carry out the duties expected of him?
Prior to appointment
Just as a prudent shareholder will not invest in a fund without performing due diligence, a potential director should not join a board without conducting a similar investigation.
He should obtain a "term sheet" from the fund's sponsor (or its lead counsel or administrator) which summarises significant fund details such as its investment objectives, strategy, investment universe and restrictions, target investors, the intended composition of its board, the investment manager and its principals, names of the service providers, valuation and dealing frequency, listing status, and other significant operational matters.
He should conduct his own due diligence on the fund's sponsors, the investment manager and its principals. Legal counsel and the administrators should have already conducted their own due diligence before accepting appointment, so general enquiries could be made with these parties. But he should be able to conduct his own due diligence by searching through relevant internet sites - its amazing what information can be found by simply conducting a "Google" search.
With respect to other service providers such as the administrator, the custodian and bankers, legal counsel, external auditors and the registrar, these should all be recognizable and well known and respected financial institutions or firms. If not, ask why not.
Should the potential director be approached to join a board of a fund in the process of being established, he may expect to be part of its "working group". The working group's task will be to prepare, negotiate and conclude all constitutional documents and agreements on the establishment of the fund. The group should comprise a number (or committee) of directors who have fund industry experience, representatives of the sponsor and / or investment manager, legal counsel and the administrators.
Once the fund is established each of the directors, as well as the service providers, should be provided with the fund's "bible" - a full set of the fund's constitutional documents including its placement memorandum, its memorandum and articles of association and all agreements with service providers (the investment manager, the administrator, the custodian, the prime broker, the registrar and transfer agent and the fund's distributor, if any). Usually lead counsel will put together and distribute the fund bible.
The director must become fully conversant with the constitutional documents and ensure they are readily available for future reference.
He should also be supplied with full, detailed contact information for all significant parties to the fund - not only correspondence and internet addresses but phone, fax and mobile numbers. Details should be included not only of the principals of the investment manager but its assigned portfolio managers and senior support staff. This will ensure that the director has access to all persons concerned with the day-to-day running of the fund.
Once the fund is up and running the director must receive regular reports, particularly from the investment manager and the administrator.
Detailed valuations should be received directly from the fund's administrator. These should not be channeled or issued through the investment manager - dishonest managers have been known to falsify such reports. The valuation package must not merely include a net asset value (NAV) figure but should comprise the following detailed accounting reports:
- balance sheet / statement of net assets
- profit and loss statement / statement of operations
- series accounting and expense allocation worksheets
- capital movements reports reconciling changes in net assets, including subscriptions and redemptions
- detailed portfolio listing showing all securities held and their percentage of net assets
- securities transaction reports detailing all securities purchased and sold during the period, realised capital gains and names of executing brokers.
Once these reports have been digested the director may require additional information with respect to certain items in the accounts such as performance fee calculations and outstanding broker balances. A competent administrator will be able to supply such reports at the director's request.
The investment manager should supply the directors with the reports which it intends to make available to shareholders on a monthly or quarterly basis.
The directors must receive immediate notification from the investment manager and / or administrator should there have been any breach of investment restrictions. The manager should advise as to how and when he will rectify the breach and directors will need to consider as to whether the manager should make good to the fund any losses which may have resulted.
The directors must have unfettered access to senior staff of both the investment manager and the administrator. He should feel free to query the managers and the administrators as to any aspects of the detailed valuations such as specific securities trades, securities pricing and unusual expense items.
He should query the investment manager should there be any items in his report to shareholders which appear inaccurate or in conflict with the detailed valuation reports or in conflict with the fund's investment policies and guidelines. Exceptional performance, whether poor or outstanding, should be discussed with the manager. The directors should be continually monitoring the performance of the manager. This does not mean that directors second guess the portfolio manager's decisions to buy or sell particular securities. Rather, the directors should look at the fund's performance as a whole against its targeted returns, its investment objectives, strategies and risks - all of which should be disclosed in the fund's placing memorandum.
Directors must ask hard questions of managers and must not be diverted until they receive the appropriate answers.
Legal counsel, or the fund's company secretary, should be in contact with the directors particularly with respect to any filings with regulatory authorities and specifically any notifications or continuous disclosure requirements to the relevant stock exchange should the fund's shares be listed.
Throughout the fund's financial year the investment manager and the directors should be in regular contact, even on an informal basis. The manager should inform the directors of any publications in which the fund's name is mentioned or where the managers have been interviewed with respect to the fund's activities. Copies of any press articles should be supplied promptly to the directors.
The directors also need to keep abreast of industry and market developments and periodic discussions with the managers should assist in this regard. Certain market developments can have immediate and serious implications to a fund's operations. A good example is when the Malaysian government introduced capital and exchange controls during the 1997 Asian financial crisis. Boards of funds with a significant investment exposure in Malaysia had to promptly convene to discuss the implications including suspension of valuations and dealing in the fund's shares.
Formal communications, particularly by way of board meetings must be held.
The board should meet at least once per year, the most appropriate time being that when the annual accounts have been prepared and audited and are ready for directors' approval and publication.
Should the fund's shares be listed then interim or half-yearly accounts may also be required to be published and submitted to the relevant stock exchange. In such circumstances formal board meetings should be held at least twice a year.
Senior representatives of the investment manager should attend the board meetings to present their managers report for the period which may be included in the published results. The manager should make a presentation to the board of their performance for the period under review, particularly reasons for deviation from the fund's targeted return, major security acquisitions and disposals and the composition of the current portfolio. They should also advise of their outlook for the coming period and how they plan to take advantage of, or minimise loss opportunities and risks under, the conditions anticipated in their economic and market outlook.
The managers should at some stage leave the meeting so that the directors may feel unencumbered in discussing amongst themselves the manager's performance.
The administrator should also be in attendance to answer any questions relating to the accounts. The administrator should particularly highlight any unusual or large items in the profit and loss account. He should confirm to the board the basis and source of valuations of all investments in the portfolio. He should bring to the board's attention any securities not valued in strict accordance with the fund's constitutional documents and applicable accounting standards. For certain asset positions the directors may be required to determine, as per its articles, a "fair price" particularly for illiquid or non-marketable assets.
Lines of credit and utilization of loan facilities should also be discussed and reviewed.
The administrator should also bring to the board's attention details of any accounting adjustments that were either made or recommended by the fund's external auditors.
The directors must have access to the auditors and I would suggest that certain of the directors, particularly those with accounting experience, meet separately with the auditors before the board meeting to freely discuss any issues which affected their audit and the accounts.
Various other important issues will be discussed such as expense ratios, dividend declarations, shareholder communications, service provider contracts and fund marketing initiatives. For a listed fund, certain issues such as dividend declarations will need to be promptly thereafter advised to the stock exchange. The board may also assign to certain directors or committees tasks to be actioned before the next board meeting.
Once board meetings are concluded the meeting secretary, who is often a representative of the administrators, must prepare and distribute the detailed minutes on a timely basis.
Composition of the Board
Regulators in certain onshore jurisdictions now require companies to appoint a number of independent directors - and certain stock exchanges will require it.
The Irish Stock Exchange (one of the most popular exchanges for the listing of shares of offshore hedge funds) requires as a listing condition that a fund company have at least two directors who are independent. The exchange considers a director to be independent where:
- he has no executive function with the investment manager or its affiliates and / or
- should he have an executive function with any other service provider (such as the administrator ) that he is not responsible for carrying out any work on that fund.
The exchange in Dublin also requires that all directors must be natural persons. That is, a corporate director (as is often provided by accounting and corporate secretarial firms ) is not permitted.
It should be noted that, at least until recently, a number of service providers, including international offshore hedge fund administrators, have provided the services of senior staff members as directors to their fund clients. It has not been unknown for some senior management at administrators to have more than 200 directorships. This business has been a good fee earner. Such directors have become mostly passive in these roles, unfortunately at a time when a diligent director must be actively involved in the fund's affairs. Recently a number of administrators have been sued and their executives who have provided these "sleeping" or passive directorships have been brought to the courts for their perceived, if not actual, lack of care and diligence. Some administrators have introduced new business policies now forbidding their staff to take up client directorships and have instructed them to resign from what they had previously considered a lucrative, (and incorrectly) risk free and effortless, side business.
With investors and regulators increasing focus on corporate governance best practice and the requirements for appointment of independent directors, the days of the passive director are rightly over.
So who should a fund sponsor consider for appointment as an independent director? Due to the nature of the funds industry the most appropriate candidates are those who have had extensive experience in the industry. Accountants, lawyers and securities professionals are a good choice particularly those who have had many years experience in providing administration, operational or legal services to the offshore funds industry. In fact, your fund's administrator and legal counsel will know of such individuals who are in a position to consider offering their services as an independent director.
A sponsor may also wish to consider well-known public figures to sit on the board. Such individuals may be able to bring a higher profile to the fund and have connections to assist in selling the fund to investors. Such appointments are quite common for single-country funds and venture capital or direct investment funds. However such persons must appreciate the duties and responsibilities involved and the extent of time required to properly perform their duties as director. Should they not have the time or inclination then perhaps the sponsor should consider the appointment of such persons to an "advisory" council or committee to the fund. Such a committee will have no constitutional powers but can act as an informal adviser to the fund and managers and act as a high profile conduit to important institutional investors.
Compensation of the Board
The sponsor has found the right board candidate with extensive experience and is aware of the duties and responsibilities involved and the time and effort required to properly perform the role. Now don't forget to pay him.
With increasing corporate governance expectations by investors, ever increasing regulations and a generally more litigious society, the days of minimal fees and retainers are behind us. Independent non-executive directors must be adequately compensated. They should receive an annual fee appropriate to the expertise they bring to the board and as compensation for their time and effort. They will also properly incur expenses in carrying out their duties, including traveling to meetings, and all such expenses will need to be promptly reimbursed.
Should a fund sponsor not be prepared to pay an appropriate director's fee then the sponsor does not, at best, fully understand or appreciate the role of the independent director or, at worst, does not intend the director to have an active involvement in managing and overseeing the affairs of the fund.
With the financial and other penalties associated with even inadvertent failure in a director performing his duties, this can lead to penalties far greater than the economic or direct benefit a director may receive from his position. A candidate may thus also require the fund to take out directors' liability insurance.
Questions about the roles and responsibilities of independent directors are at the top of today's discussions on corporate and fund governance.
Independent directors act as a "watchdog" for investors over the fund manager and other service providers to the fund. They act as agents for fund investors. They bring impartiality and experience to a fund's board and its oversight of the fund's affairs and activities.
The motto of the independent director is - The shareholder is king.
* Mark Beames acts as an independent non-executive director to several Asian offshore hedge funds as well as an Australian listed fund of funds.
From 1988 to 2003 he was the Managing Director of Fortis Fund Services in Hong Kong and oversaw the provision of advisory, administration, corporate secretarial, custody and banking services to over 140 investment funds with assets in excess of US$5 billion.
He is a Fellow of the Institute of Chartered Accountants in Australia and a Member of the Australian Institute of Company Directors. He presently resides in Australia.