Madeleine Cordes from Walkers Corporate Services discusses corporate governance for Cayman investment funds.
Amid such volatile investment markets, the ability of hedge funds to demonstrate compliance with robust corporate governance practices has never been more pressing. This has been particularly important in recent years as institutions have played a more significant role in sponsoring hedge fund structures. Institutions are increasingly looking for strong governance in the funds in which they invest and themselves have implemented more stringent due diligence requirements when making their investment assessments.
While no specific corporate governance structure with regard to investment funds actually exists in the Cayman Islands, an informal framework has developed over the years. This incorporates elements of various international laws and codes, particularly from the UK and the US. The Alternative Investment Management Association has also been at the forefront of developing best practice in the hedge fund arena. The UK’s ‘principles-based’ corporate governance system, which evolved into the Combined Code (Principles of Good Governance and Code of Best Practice), requires companies to comply with regulations or they must explain why they have not done so in their financial statements. The Sarbanes-Oxley regime for listed companies in the US, meanwhile, provides for heavy penalties and sanctions for non-compliance. Service providers in Cayman need to ensure that the appropriate corporate governance standards are being maintained, not only because of investor pressure, but because many parent companies of clients will be bound by these international regulations and therefore these will be expected to flow through the client’s organisational structures.
Where Cayman funds are listed, there will be additional requirements. A fund which is listed on the Irish Stock Exchange will be required by listing rules to appoint at least two independent directors while one listed on the London Stock Exchange will require a majority of independent directors, an independent Chairman and not more than one director who is involved with the investment manager.
Key corporate governance issues relating to funds are the processes by which Board decisions are made, as well as the selection and independence of directors. The essential point is to be able to demonstrate that corporate governance is not simply an exercise in ticking boxes. “Behavioural” governance is the latest buzz word to emerge in the market place but this essentially means that the parties act properly because it is the right thing to do, not because they are just meeting the requirements of some code.
Board meetings need to take place – this is particularly important where there are independent directors on the Board as otherwise how will they be able to effectively monitor the fund and be involved in the decision-making processes which will end up bypassing them? If Board meetings are not held, decisions will be made informally, with no record kept, and not necessarily with the right parties being able to contribute. Once the premise of having Board meetings is accepted, these meetings will then need to take place on a regular basis.
In terms of frequency, while an annual meeting to review financials might be sufficient for an inactive fund, best practice in the current climate would see Boards meeting three or four times per year, which then allows for current market updates from the investment manager and effective strategic decision making. Ad hoc Board meetings should also be convened in between regularly scheduled meetings to deal with one off matters such as the appointment of a new director or service provider. Establishment of independent pricing committees is also key. These should have agreed terms of reference.
Face-to-face meetings are also important. While conference calls are easy to set up, directors do not get the ability to look directly into the investment manager’s eyes when asking any tough questions and there are often technical difficulties which make the meeting less efficient. To achieve best practice, Boards should look to ensure that at least some meetings are held around an actual table and it makes sense to bring everyone to Cayman where the fund is domiciled at least once per year, which will help demonstrate that control of the fund does not rest solely with the investment manager who will typically be based in the US or Europe. Taxation issues should also be considered when planning Board meetings in different jurisdictions.
Board papers need to be comprehensive but not overwhelming and must be sent out in good time, allowing attendees to read them in advance and be able to ask relevant questions at the meeting. For security, cost and environmental reasons, there is an increasing trend towards Board papers being emailed for printing by each attendee at their own offices, rather than couriering packs, with a couple of hard copy packs available at the meeting itself. This does inevitably lead to a lot of email traffic and Walkers Corporate Services is developing a web portal where Board papers can be accessed and downloaded at leisure by attendees, and historical papers stored for future reference.
During the meeting, the investment manager should provide a comprehensive verbal current update on the state of the market and the fund(s) as well as the most historical written report included with the Board papers. This will effectively educate the directors and guide their decision making on matters relating to the fund’s investment policies and strategies. Compliance reports should be included in reports given by all providers to whom functions have been delegated, including any breaches of the investment policy, any AML issues and any complaints from investors. Service providers should be encouraged to give detailed verbal reports – reports should not be taken as read. Minutes from any independent pricing committees should also be reviewed. Any contracts that have been entered into between meetings under the Board’s delegated authority will need to be ratified, so that the rest of the Board is brought up to speed, for example contracts with service providers or trading and brokerage agreements. Any pricing by the investment manager or other non-independent pricing should be reviewed or ratified too.
Financials will be reviewed, whether they are half year or annual figures, although separate audit committees or meetings are often better placed to deal with detailed accounting queries, so that time is not wasted in the actual Board meeting. The audit committee will typically be comprised of the independent directors who will meet separately with the auditors.
It is important that any independent directors really do add value, drawing on their experience. One positive outcome of the current difficult investment climate has been the push for good quality directors. The greater availability of well qualified, career-minded independent directors has helped the industry, so funds do not have to be limited to retirees and friends from the golf course. Often it can work to the fund’s advantage to have an experienced director that sits on a variety of boards. Providing there are no conflicts of interest, the independent director is able to observe industry best practice and contribute this knowledge to the fund.
The ideal Board composition will very much depend upon the size of the fund, and even independent directors in a minority on a Board will bring some value. In line with AIMA recommendations, having a majority of independent offshore directors can be seen as a typical example of best practice. Corporate governance decisions, however, such as the cost of independent directors, should always be taken with the performance of the fund in mind. Just as it is important to strike the right balance of governance, it is important that the fund gets good value from its independent directors.