Alternative Investment Management Association Representing the global hedge fund industry
Stuarts Walker Hersant
What is an Independent Director?
In January 2008, the Alternative Investment Management Association re-published its Offshore Alternative Fund Directors’ Guide (the 2008 Guide) recommending that, in order to be considered properly independent, a director should have no executive function with regards to the fund’s investment manager, investment adviser or affiliated companies. Alternatively, a director may hold an affiliation but have no responsibility for carrying out work on behalf of the fund. In the writer’s view, this should be complimented by a clear and transparent code of conduct and a conflict of interest code to be adopted by the fund board.
The 2008 Guide states that independence has become an essential element from an investor expectation perspective, as well as with regard to relevant listing rules. Such rules clearly impact the makeup of any board as requirements become more stringent, with the majority of stock exchanges requiring that each fund has at least 51 percent of the board as independent or the creation of a supervisory committee.
Scrutiny as to what it means to be an independent director and the correct standards to be applied is increasing across the board. The United States Government Accountability Office January 2008 Report (the GAO Report) outlines the steps taken by the US Securities and Exchange Commission to oversee hedge fund advisers by appointing examiners to inspect the typical activities of advisers. One of the areas in which the examiners focus is that of the activities of boards of directors for offshore funds and the fiduciary duties of such board members to the shareholders of the funds and consistent disclosure to investors.
Over time the best practice interpretation of independence may be expanded to require that the director has no other direct or indirect involvement with the fund or its service providers or advisers. There must be a question whether the fund’s legal counsel (or employees of its service company) can properly qualify as independent. Also, can someone who sits on the boards of multiple funds sponsored by the same investment manager and who generates significant income from those positions, still be considered truly independent?
Conversely, is someone who guards his position as an independent, to such an extent that he restricts contact with the promoter and/or manager of the fund, running the risk of becoming out of touch and uninformed? Where does the balance lie and, once identified, is such a balance possible to achieve?
What are the basic duties and responsibilities of the Independent Director?
Noting that there may be some distinctions between jurisdictions, a director has a duty to act in good faith and in the best interests of the fund and to exercise due care. He must act loyally and should not exercise his powers for an improper purpose nor misapply the assets of the company and ensure there are no conflicts of interest. All powers should be properly discharged and approved and there should be no secret profit from his position as a director.
Conflicts are becoming increasingly difficult to avoid as the complexity of the average fund means that service providers are providing fiduciary, administrative and legal services, albeit with different hats and talent pools which consist of limited numbers.
How should Independent Directors apply such principles to an offshore fund?
Good independent directors should satisfy themselves that the fund is properly structured and transparent to investors; has the necessary checks and balances in place; has made the proper disclosures to investors and regulators and is legally compliant. They will ensure that systems are in place so that they are made immediately aware of material issues that arise with respect to the fund. They will be actively involved in addressing problems, such as regulatory investigations. Regular and substantive reports and board meetings are essential.
There is an expectation that a director owes a duty to the fund on whose board he serves in turbulent times as well as times of tranquility but many say the burden now outweighs the compensation.
It is clearly important to the health of the industry that good board members do not feel forced to resign due to the pressure of the increased regulatory burden or personal liability risk. The question is, are the correct procedures in place and are there sufficient numbers of willing and qualified directors willing to step up to the plate?
The key is to maintain a balance between the various interests. Independent directors should be entitled to reasonable remuneration and protection for their services. Equally, they should not be protected from liability if they fail to meet their obligations to the funds (and ultimately the investors) whom they are paid to serve.
Is it possible for Independent Directors to save a fund?
A number of fund boards have been required to assess internal management performance and provide written explanations to shareholders. Written policies have been adopted by a number of prominent boards with a view to promoting better practices and to prevent the fund from violating securities laws and to comply with the constitutional documents.
In some recent high profile examples, how may Independent Directors have helped?
o Illiquid/hard to value securities
Fund managers allegedly depleted funds, by investing in a small number of unlisted, infrequently traded companies. Portfolio assets were used to acquire controlling stakes in worthless companies by purchasing securities through private transactions. Unrestricted shares were then purchased at a higher price. Shares were then registered at a higher value, inflating the fund’s NAV. Allegedly the administrators of the fund failed to act despite the apparent increase in the fund’s value at a time of poor market performance.
An independent director may have demanded a timely response from the administrator but is it fair to insist that directors have a solid understanding of their funds investments and the actual basis of valuation? Increasing the director’s role (and fee) may be the answer. However directors to whom the writer has spoken were reluctant to agree to the additional exposure, even for an increase in fee.
Lack of independent verification of valuations
Liquidators filed a complaint alleging that fund managers had ignored extensive independent broker values by substituting internal valuation methods that failed to reflect security values. Allegedly, “hedge adjusting” pricing was applied that did not truthfully evaluate the securities.
Disagreement over responsibility for valuation remains a recurrent theme. The employment of an independent director may have ensured that the fund administrators performed independent valuations and not relied solely upon the fund manager’s valuations without questioning the valuation methodology.
Recent Case Law
Recently, the US Bankruptcy Courts have considered applications by Cayman Islands registered funds for protection under Chapter 15 of the US Bankruptcy Code (Chapter 15). This is essentially an ancillary application to a primary proceeding being brought elsewhere. The US Bankruptcy Court must be satisfied that the primary proceeding is either a “foreign main proceeding” (where the debtor’s centre of main interest (COMI) is located or is a “foreign non-main proceeding” (where the debtor has an establishment but no COMI)).
The Bankruptcy Courts declined to recognise the Cayman Islands proceedings in any form and found that the funds’ COMI was located in the US in the absence of evidence to the contrary. The fact that there were two directors resident in the Cayman Islands and that other ancillary activities took place there, were considered insufficient to support a finding of COMI or even of an establishment in the Cayman Islands.
In light of these decisions, it is possible that, in future, fund directors may find themselves open to question if they have not structured the operations of the funds correctly and ensured that sufficient measures have been taken to ensure that the fund’s COMI is clearly offshore. Parenthetically, there are also potential and adverse onshore tax consequences for a fund if its mind and management or central control is not found to be offshore. Careful structuring and ongoing operations are required to avoid potential outcomes of this kind.
Prudent investor due diligence requirements increasingly demand effective and demonstrably independent directors and an assurance of a robust action by directors ensuring the fund is properly structured and operated and that the exercise of proactive oversight, over key areas of the funds operations, is maintained, e.g., asset valuations and the ability to swiftly identify, investigate and deal with any deviations. The role of the independent director is a critical one and of growing importance as the hedge fund industry matures and the investor profile expands.
The attention now being given to the role of the independent director is leading the industry in some offshore jurisdictions to consider the desirability of enhancing the standing and credibility of the profession and the development of best practice codes of conduct, ethics, conflicts of interest and the like. One example is the proposed forum currently being developed by a group of independent Irish directors. Another is the Cayman Islands Directors Association (CIDA), an association consisting of directors of one or more Cayman Islands registered companies, which have recently been incorporated and whose purpose is to promote and safeguard the interests of directors of companies registered in the Cayman Islands. CIDA will seek to define a code of conduct and best practice for its members, with a view to ensuring corporate governance of the highest standard, thereby further strengthening the integrity of the Cayman Islands financial services sector. Plans to provide educational programmes in conjunction with the Cayman Islands Monetary Authority are already under way.
It seems likely similar steps will be taken in other offshore centres. This is to be welcomed as a natural move given the growing maturity and size of the fund industry.