In the European hedge funds industry, the majority of hedge funds are offshore (mainly Cayman) companies whose governing bodies are their boards of directors. These boards are made up of a number of individuals who act as non-executives directors (NEDs). Part one of this note attempted to identify the key functions of the governing body in general. Part two considers the future of the fund board in particular, but cautions investors against expecting too much from the governing body (whatever form that may take).
The need for principles
A corporate fund is very different to a company that does not carry on investment business, especially where the fund is open-ended. The main differences are:
- a fund board is entirely composed of NEDs
- a fund does not have any employees or executive directors so all day-to-day tasks are delegated to third party service providers
- at least in the case of open-ended investment companies, sometimes the fund board will have to balance the interests of ongoing, outgoing and, sometimes, incoming shareholders
Despite these differences, however, fund directors owe the same high-level duties to their funds as company directors owe to their companies. The lack of accepted and sufficiently detailed principles regarding the duties and functions of a fund’s board of directors has led to a diminished understanding on the part of some fund directors and inflated expectations on the part of some investors.
Yes, there is AIMA’s Offshore Alternative Fund Directors’ Guide (which was last updated in 2008) and yes, there are the Fund Governance Standards of the Hedge Fund Standards Board. But despite this guidance, one of the most striking things about the impact of the Weavering judgement was the way in which the industry became so animated by the judgement’s discussion of the specific duties of a Cayman fund director. Finally, here was “official” guidance.
How this guidance is treated in the future – be it binding precedent, instructive/persuasive passing remarks or irrelevant personal opinion – it is clear that what is missing is for managers, investors, regulators and the courts to accept a realistic framework for industry best practice that has been designed for, and is appropriate to, corporate funds.
The Association of Investment Companies has published, and regularly updates, a Code of Corporate Governance for its members. I believe that the hedge fund industry needs to develop (and regularly update) its own code along the same lines, whilst recognising that the AIC Code is set at an appropriate level for funds (mainly closed-ended), that are listed on the London Stock Exchange and accessible to retail investors.
This code needs to be driven primarily by hedge fund investors and should ideally be applicable to every type of fund vehicle and governing body.
The need for fund-specific legislation or regulation?
Currently, most fund vehicles will be subject to both local funds law and local law relating to the relevant type of fund vehicle (e.g. a Companies or Limited Partnerships Act). As mentioned above, directors of a corporate fund will be subject to the same laws regarding company directors and this may not be appropriate.
Funds that are companies should not be treated in the same way as companies for all purposes and fund jurisdictions should consider carving fund vehicles out of the standard law relating to local companies, partnerships etc. or, at least clarifying the role of a fund’s governing body (whether by legislation, regulation or guidance).
The UK’s Open-Ended Investment Companies Regulations (OEIC Regulations) are a precedent for this approach. UK open-ended investment companies (ICVCs) are subject to OEIC Regulations and FSA rules and are essentially not subject to the Companies Act 2006 or the related common law. The operating duties and responsibilities of the directors of an ICVC are set out in the Collective Investment Schemes sourcebook.
Not enough NEDs to go around?
In order to keep the fund offshore for tax purposes, the majority of the board should be offshore. The majority of the board should also be independent. Finally, the board should also have suitable collective ability, expertise and experience.
The result of these restrictions, a result that is exacerbated by local law sometimes requiring the appointment of one of more local directors, is that there is not a large talent pool of NEDs to draw from.
There are also limited ways to access this pool effectively: professional firms, service providers, prominent industry figures and the manager’s network of contacts (including ex-employees) are probably the main sources.
The combination of these factors has unsurprisingly led to the emergence of the so-called “jumbo directors”, who sit on the boards of many, sometimes hundreds, of hedge funds.
Is the industry obsessed with individual NEDs?
It certainly would seem so. It would appear to be one of the many self-fulfilling “standards” in the industry.
Whilst keeping the fund offshore for tax purposes will always be the overriding factor in structuring a hedge fund board, the industry should consider the increased use, and involvement, of legal persons.
This could either manifest itself in a fund just having one corporate director (compare the role of a trustee in a unit trust or the general partner in a limited partnership); a fund having one executive corporate director and one or more NEDs to monitor the corporate director (compare the roles of the Authorised Corporate Director and other directors of a UK ICVC) or a fund giving a much larger and more active role to the company secretary to ensure good governance practices (where the company secretary should be separate from the administrator).
Some specific issues with current practice
A few common practices surrounding fund boards need to be considered.
Firstly, a director’s appointment is almost always under the articles alone and there is no contract or even a letter of appointment. Given the lack of accepted guidance, this practice should change so that there is a record and mutual understanding of the director’s role, responsibilities and expectations.
Secondly, a hedge fund director usually has unrestricted power to appoint one or more alternate directors – i.e. the director can appoint a person who can act as a director in his or her place. Whilst the appointment of an alternate director may sometimes be justifiable in the circumstances, the simple fact is that the directors of record may not actually be the directors who are making board decisions. On this point it is interesting to note that FSA rules prohibit a director of a UK ICVC from appointing an alternate director.
Thirdly, a hedge fund board frequently delegates its powers to a committee of just one director. Whilst there are often administrative benefits for the board to delegate a decision to a one director committee, the use of such committees needs to be carefully monitored and, where there is doubt as to the authority of the committee, the full board should be asked to make the decision.
Finally, fund directors will typically be entitled to be indemnified by the fund under the articles of association. This indemnity may render any potential recourse against them inadequate, especially as the “standard” indemnity covers negligence. Whilst the risk of personal liability for a fund director should not be so high as to reduce the talent pool any further, the industry needs to establish a reasonable standard of care for fund directors, who also need to accept the personal consequences for sufficiently failing that standard.
Investors should not expect too much
Hedge fund governance needs to be improved, yet, even if the necessary improvements are made, investors need to appreciate the legal, fiscal and practical limitations on a fund’s board. Having good hedge fund governance will never guarantee the protection of a particular investor’s interests but it should significantly improve the chances of an investor being able to take steps to protect its own interests.
Governance arrangements should be carefully considered when structuring, and when investing in, a hedge fund. They should be periodically evaluated by both manager and investor and, if necessary, changes should be made even if – heaven forbid! – the arrangements cease to conform to the “market standard”.