Corporate governance challenges for hedge fund boards
By James Oussedik, Counsel, and Jeremy Leggate, Associate, Sidley Austin LLP
Published: 30 June 2014
In part fuelled by scandals and significant cases over the past few years (those relating to Madoff and Weavering, for example), managers are by now well used to engaging with increasingly probing questions from investors around governance arrangements and the independence of fund boards.
In this article, we will seek to explore where we are in the on-going governance debate, and where we are likely to get to in the near term, as the industry faces yet more governance challenges arising from investor pressure and regulatory change.
Where we are: governance in major fund jurisdictions
All major financial jurisdictions require fund directors to exercise care, skill and diligence in the performance of their duties. In the UK (and most other common-law based jurisdictions) this is measured against an objective standard (i.e. a minimum level of performance expected of all directors), uplifted according to any particular knowledge, skill or experience a particular director may have. These common law principles are supplemented by further laws, regulations, codes of conduct and statements of guidance, issued by both regulators and industry bodies.
The world of fund directors is however, peculiar – fund directors are bound by the usual rules applied to company directors, yet their ability to ensure they discharge the duties laid upon them is curtailed by the fact that day-to-day activities and management of the fund are delegated to service providers, including the investment manager. Moreover, although independence of judgement is a crucial requirement for fund directors, there is often a very close relationship with managers (not least due to the fact that managers will typically play a lead role in selecting directors and setting the level of their remuneration).
The Weavering1 judgement has further developed the theory of directors’ duties in the context of offshore funds, recognising that although much of the day-to-day operations of a fund can be managed by the fund's service providers, directors must take an active role in supervising the fund's affairs and its business, and apply their minds and independent judgement to the decisions they make.
In the face or criticism and investor pressure, certain regulatory authorities in fund domicile jurisdictions have also released new guidance concerning the role of independent directors, summarising existing legal and best practice requirements (Cayman Islands Statement of Guidance for Regulated Mutual Funds (CISOG-MF)), or issued codes of practice on a comply or explain basis (Guernsey Financial Services Commission 'Updated Guidance on Corporate Governance Guernsey’).
The key areas which the new codes of practice cover are:
- Degree of Delegation: by way of example, section 14.2 of the Irish Governance Code (“IGC”) states that, regardless of the extent of any delegation of management functions, “the Board cannot abrogate its overall responsibility”. CISOG-MF describes the fund's governing body as “the directing will and mind” of the fund with 'ultimate responsibility' for directing and supervising the fund's activities. How easily this can be extended to the fund’s investment activities will depend on the complexity of the manager's investment strategy, the extent of the manager's responsibilities as defined in the investment management agreement and the sophistication of the investors in the fund. Something stressed in section 1.3 of the CISOG-MF.
- Expertise: the board collectively must have sufficient knowledge and expertise not just to understand the manager's investment strategy and the risk profile this creates for the fund, but also to monitor compliance with investment strategy and evaluate performance. The IGC recognises that having a person affiliated to the manager on the board is a necessary component of maintaining sufficient oversight of the fund, i.e. directors being able to monitor and supervise the manager’s strategy and performance.
- Independence: all corporate governance codes insist that directors, as a minimum, exercise independent judgement, and most corporate governance codes recommend that boards have at least one independent director. These essentially restate existing legal principles that are found in most major financial jurisdictions. A significant difficulty for managers is finding a pool of experienced and credible individuals who are truly independent, and not affiliated to a service provider.
- Jumbo Directors: in the Cayman Islands the average fund director sits on 25 boards, and over 15% of Cayman directors are retained by 25 different managers to sit on their funds’ boards2. Most corporate governance codes have declined to take a robust approach on this issue. The CISOG-MF, mindful that the number of directorships an individual can competently discharge is contingent on a number of factors, states that the board should “consider carefully” the number of directorships a potential director holds. In its Corporate Governance Survey, CIMA found that respondents were more or less split evenly over the issue of limiting the number of directorships that can be held by an individual. The alternative case is the IGC, which has introduced a presumption that a fund director should hold no more than eight non-fund directorships, and where a fund does appoint such a director, the board must fully explain its reasons to investors in their directors reports accompanying the annual audited accounts.
- Remuneration: the Association of the Luxembourg Fund Industry (ALFI) published its revised Code of Conduct in 2013. Recommendation 10 of the revised Code states that board remuneration should be “reasonable and fair and adequately disclosed”. However other relevant jurisdictions have not taken up the issue as yet. This is most likely due to investors effectively self-policing the issue.
The comparison with listed companies
It is sometimes felt that governance standards in the alternative funds industry lag behind standards in the more mainstream world of listed companies.
In actual fact, as the table below illustrates, the standards which are applied are very similar.
One of the main differences may be however, the public nature of the role of directors of listed companies against the very private role of fund directors. With transparent and live share prices, directors of these companies have had an ever-present corporate barometer, one that fund directors have not. As a result, investors in private funds have had to take a much more active role in setting and policing standards.
Contrast with the US
Whilst governance standards in the context of European managed funds continue to be debated, it is striking to note that the most sophisticated alternative investment market in the world has not experienced the same phenomenon – why is that?
In the context of UK managers of offshore funds, the historical reason for good corporate governance, specifically board independence, was heavily linked to UK tax compliance and mitigating the risk of “onshoring” the fund. The same risk in the context of a US fund does not exist to the same extent.
US funds have historically tended to be structured as limited partnerships, in which the general partner was (and generally still is) an affiliate of the manager or sponsor of the fund. The nature of the relationship between limited partners and a general partner, as opposed to shareholders and a fund board, is significantly different, not least due to the fact that in most jurisdictions there are at least some basic partnership duties owed between partners, and direct contractual privity. US investors have tended to focus on specific elements of governance, such as related party transactions, audit, adherence to a code of ethics, adviser remuneration, and monitoring of investment policies. In the environment of ’40 Act funds, there is also a requirement to ensure that a proportion (not always a majority) of directors are independent.
Many large US allocators to alternative investment funds will also seek to agree specific governance requirements and standards of behaviour with managers and funds, including by way of side letter provisions.
Potential developments in governance
For all the increased activity around corporate governance, there appears to have been no significant watershed in the ways in which fund boards and managers interact in practice, nor generally in the approach which directors of funds take to the discharge of their duties, provided they were taking their duties reasonably seriously in the first place.
This perception is supported by recent industry surveys, which illustrate that a minority of investors believe that fund boards are carrying out their duties to a sufficient standard, and a smaller minority still believe that boards retain sufficient authority and knowledge to allow them to challenge the manager.
Given this apparent lack of satisfaction, what are the likely future trends in governance for the European funds industry?
For those investors who are large enough and sufficiently sophisticated, the move towards managed accounts and funds of one seems an obvious way in which to mitigate concerns and risk around governance. Such structures now generally provide that the investor is responsible for the fund structure, not the manager, and accordingly affords the investor freedom to establish such governance arrangements as it wishes, provided these do not overly inhibit the manager’s ability to carry out its investment mandate.
Another potential method by which investors may gain more certainty around governance is by seeking to confirm certain duties of the board, and responsibilities of the manager, in a contractual agreement or side letter. This mechanism gives key investors the flexibility of remaining in a commingled fund whilst providing greater comfort in relation to fund governance.
Seed investors are uniquely positioned to influence the terms and, in some cases, the governance structure of the funds they invest in. The implementation of robust governance structures may also provide the fund and the seed investor with opportunities to differentiate and provide a competitive marketing advantage.
Continued focus on fund governance
In an environment where alternative investment funds have long since ceased to be the preserve of ultra high net worth individuals, and are now an increasingly important part of pension and insurance portfolios, it would seem very likely that the focus on fund governance is set to continue. Recent trends suggest that regulators rather than investors are likely to take more of a lead in setting and policing standards, both through regulations and codes of conduct imposed on the fund and on the manager. It remains the case that in order to work satisfactorily, managers, fund boards, investors and regulators each need to maintain dialogue and seek to ensure that governance standards are appropriate and do not become a millstone impeding commercial decisions and, ultimately, performance.
 Weavering Macro Fixed Income Fund v Peterson and Ekstrom [Cause No. FSD 113 of 2010 (AJJ)]
 Foundation for Fund Governance - https://www.fundgov.org/