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
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
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
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
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
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
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
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
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
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
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
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
* 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.