Spotlight: Fund governance

The Grand Court decision in Weavering has put the spotlight on the role and duties of fund directors and other service providers as well as fund governance in general. Panellists at the Cayman Fund Focus explored once again the different expectations of fund managers and investors and one fund director called for more regulation of the profession.

When the Grand Court found two fund directors of the Weavering Macro Fixed Income Fund guilty of wilful neglect or default in the discharge of their duties, some predicted it would shake up fund governance. Many fund directors, in contrast, used the verdict as a marketing tool, arguing why the case proved that their own services had been superior all along.

The Cayman Fund Focus a conference, hosted by law firm Campbells, dedicated its entire day long agenda to the fallout of the case. Yet both investors and fund directors agreed that the specific circumstances of the case were in no way indicative of what is general practice among Cayman service providers and that the services rendered are often of a high standard.

However, the discussions also laid bare the significant gap that exists between what investors expect from service providers for a fund, in particular from the fund directors, and what fund managers and their legal counsel expect.

In the US where funds are structured as a general partnership there is the notion that there really is no need for a fund director, said Boris Onefater of Constellation Investment.

“Managers are not looking for a whole lot of involvement. But I do think that investors are looking for the directors to be involved, which is probably in conflict with what the managers and attorneys are looking for,” he said.

Despite this “tug of war”, Constantine Arides, a lawyer with Smith Reed said manager expectation had changed quite dramatically. “Earlier on in my career the question was why do we have to pay the director to do anything? I am going to make all the decisions anyway. The answer was in this jurisdiction you will have to have a board and the manager would say find someone who is not expensive and will not get in the way.”

As the climate has changed post-Madoff and the question of how to attract capital becomes more prevalent, investors rightly insist that these corporate governance functions are in place, Karides said.

Board’s role and expertise

In an ideal world one board member at least should be able to understand even the complex investment strategies of a fund. How else can the directors discharge their obligation to the investors? Constantine asked.

But under the fiscal realities of a hedge fund and the current model that is not going to work, said Onefater.

“If I had a choice directors should get paid a little more and the duties of directors have to be discharged in a full and comprehensive way,” he said. “The bigger risk that I see is the knowledge. There are some sophisticated strategies, even if you understand what the manager is supposed to do, it is difficult to understand the implications of a specific trade.”

Fund-of-fund investor Jason Papastravou, founder of Aris Capital Management, in contrast does not want a shadow fund manager but is more concerned with directors actually exercising the limited duty of care that they do have.

“What I expect the directors to do is exercise some honest independent judgment. I don’t want them to be experienced in portfolio management and know everything and second guess the manager.”

Instead the director can and should know whether the service providers are proper, that there is a functioning valuation process and whether the auditors are receiving all the information they are asking for from the manager.

“For the investors the presence of the director is like an insurance policy. We cannot be there and overlook the fund process every day,” Papastravou said.

Director independence

Speaking from personal experience about the independence of directors he added: “Where I am much more upset is when professional directors end up being the manager’s best friend and not taking the side of investors. And not only that, they go to court and testify in favour of all the lies and the misdeeds that the manager has committed.”

Alternative forms of fund governance such as advisory boards as they have appeared in the US did not meet his approval. “Advisory boards are not serious boards,” Papastravou said, adding any board that does not have any power just exists for show.

Papastravou believes the corporate governance of US funds is lacking a necessary effective oversight function and each jurisdiction has to decide if it is “going to be set up for the manager or for the investor”.

Weavering on the other hand was not something of a concern for him because the case was so blatantly wrong and had many red flags, such as the manager being related to the directors.

Meanwhile the panel agreed that fund directors coming from service providers active for the same fund is nothing other than an inherent conflict.

Due diligence

Irrespective of the extent of the role of the fund director and other service providers investors have to do their own due diligence on the fund, the manager and the service providers, panellists said. In addition it is critical to understand the content of the placement memorandum and what the fund invests in, Onefater said.

According to Papastravou the auditor is the most important service provider and fraud is the key risk for investors. Due diligence is essentially the search for red flags, but some red flags may be intentional. If the fund manager is well meaning some things can actually be changed, he said, for example a not well known small auditor can be replaced with a more reputable one.

Constantine however noted that not all investors have the same negotiating power with the manager. “There is still a dance that goes on and it is not the same for all the investors.” Failing any negotiations investors can only vote with their feet and choose not to invest in a fund.

In a post-Madoff world simply insisting on a well know auditor or legal counsel for the fund is not enough, warned Constantine.

It is much more critical to understand what the service providers are actually doing, what the administrator’s role is, how much authority the administrator has over valuation and how independent the board really is, he said.

What’s your number?

On the contentious issue of how many directorships an individual can effectively take on and the transparency of their personal number of directorships, panellists were in agreement that simply giving a number could be dangerous and not tell the whole story.

Some institutional investors have in the past campaigned for the number of directorships that an individual director holds to be made public, suggesting that too large a number would prevent directors from discharging their duties effectively.

While acknowledging that it can give investors an idea of the resource capability of the director, Intertrust Cayman’s Warren Keens said, one has to be careful what to disclose and what additional information to give to an investor because it could be meaningless.

For example, a directorship of a segregated portfolio company with 20 segregated portfolios would count as one entity. At the same time sitting on a larger number of boards shows how experienced the director is and the benefits he can bring to the fund from his experience of being on boards of companies in the same industry, Keens said.

DMS Management’s David Bree said rather than give a number, he would show an investor exactly the volume of work that he is doing on a fund they are interested in investing in. “I would explain how a professional service firm works and what resources are available to me to achieve the objectives of fund governance.”

Onefater noted that in the case of Weavering the number of directorships would have been meaningless because the directors only sat on one board but they did nothing.

In US litigation the issues around the number of directorships had cropped up, said Keith Miller, a lawyer with Paul Hastings, but the main focus is typically on quality rather than quantity.

DMS Management’s Don Seymour, who, like Bree, was named by an article in the Financial Times in November as one of the fund directors in Cayman with the highest number of directorships, said there should not be a cap on the absolute number of directorships.

However, the Cayman Islands Monetary Authority should be enabled to determine whether individual directors are able to discharge their duties in an effective way.

“I do think this is a resource question and certainly there is a limit to what any one director can do. My issue is that it needs to be adjudicated by someone from an independent perspective because not every person has the same capacity,” he said. “There should not be any sort of hard cap but I do think that CIMA needs to be empowered to make capacity decisions.“

Regulation of fund directors

Seymour also called for the general regulation of fund directors by CIMA and the introduction of a director disqualification regime. “I think that CIMA needs more power over the way directors run their business. To bring what is a very core function in the fund control structure under the regulatory ambit would be really good for the industry,” he said.

Currently the conduct of hedge fund directors is governed by a combination of common law duties and specific regulations in the Mutual Funds Law that extend to corporate governance but there is no codified regulation. One option would be to codify directors’ duties in the Cayman Islands Companies Law similar to what has been done recently in UK law.

The directors’ disqualification regime resonated well with RJ Berry the head of CIMA’s compliance division, who stated that combining the requirement of the Mutual Funds Law’s fit and proper person test with a disqualification regime, would remove some of the question marks over the currently weaker ability of CIMA to “substitute” a director.

Papastravou supported a disqualification regime from an investor perspective, saying he would like to see that directors who do not act to protect investors when problem emerge should be prevented from being fund directors.

On the whole panellists concurred that the Weavering decision has not really changed all that much for directors in Cayman.

“The clear message is that being a director has always been serious,” concluded Bree. “You need to make sure that you have the infrastructure. It is not a position that should be taken on lightly.”