By Kathleen Celoria
Offshore hedge funds commonly have independent directors to ensure the funds are being operated in the best interest of their investors. But what exactly can and should an independent fund director do – and what is out of their purview?
For investors the issue of quality fund governance has moved front and center. In the recent Weavering Capital decision in the Cayman Islands, two independent directors of the failed UK global macro hedge fund were ordered to pay $111 million in damages following the finding that they were guilty of willful default in failing to properly discharge their duties. The Madoff fraud and the handling of multiple hedge fund failures, restructurings and lockups resulting from the financial crisis have also signified the importance of quality fund governance across a variety of investment structures.
Because hedge funds are usually sponsored and created by the fund manager, the fund manager may not be able to – or may not be perceived as able to – make certain decisions in the best interest of the fund. Situations of potential conflict are more likely to arise during crises, distressed markets or periods of poor performance rather than in good times. For example, in a crisis, investors may prefer to liquidate a fund immediately and accept a potentially lower return while the manager may prefer to hold assets to capitalize on potentially higher returns in the future.
What value does an institutional fund director bring to a hedge fund? Independence and industry expertise delivered under their duties and responsibilities. Director duties are owed under law and are unchangeable. Director responsibilities are contractual under the fund documents and can vary widely from fund to fund. A fund director is ultimately responsible for proper and diligent oversight of a fund’s major service providers, which include the investment advisor as well the administrator, auditor, prime broker and legal counsel. Fund directors should also review the fund’s financial statements and satisfy themselves that the financial statements fairly represent the financial affairs of the fund during the applicable audit period.
In addition to their duties under common law, fund directors typically undertake the following responsibilities:
• Advise on board structure and efficient operation
• Conduct quality board meetings and have ongoing interaction with the fund
• Ensure the fund operates in accordance with its established fund documentation
• Review and execute all fund-related documents and directors’ resolutions
• Delegate and monitor performance of major service providers to the fund
• Serve as liaison between service providers for conflict resolution
• Waive or reduce notice periods, frequency of redemptions, application of gates and payment of redemption proceeds
• Approve permissible side letters that do not prejudice other investors in the fund
• Review and approve annual audited financial reports
• Review regularly published performance information and investor letters
But as much value as fund directors do bring, it is important to understand what they do not and cannot do. The board of a hedge fund serves in a non-executive capacity and, therefore, is not involved in the day-to-day investment management business of the fund. Importantly, this means that directors are not making investment decisions or monitoring the performance of the staff at service providers.
Directors must operate the fund strictly in accordance with its fund documents and should not interfere with the business of the fund by involving themselves in minutiae and matters outside the scope of their responsibility. Times in which independent directors seek involvement outside the scope of their responsibilities can cause serious dysfunction and be detrimental to the fund and the interests of its investors.
The U.S. Securities Exchange Commission promulgates four pillars of investor protection which directors must strive to uphold:
• Investments will be managed in accordance with the fund’s investment objectives
• The assets of the fund will be kept safe
• When investors redeem they will get their pro-rata share of the fund’s assets
• The fund will be managed for the benefit of the fund’s investors and not its service providers
Outside of the typical assigned responsibilities, professional, independent fund directors can often provide benefits to the fund’s stakeholders through meaningful industry insights and transparency reports regarding their engagements with the fund. A seasoned board of directors can be a valuable resource for the investment manager by delivering advice about maintaining a sound operating environment and best practices. Board directors should also provide ongoing market intelligence on material industry developments that impact the fund plus maintain accessibility for consultation and direct communication with fund investors on material issues as needed.
By becoming more aware of the role of independent directors and more engaged in interactions with them, stakeholders can not only trust that their directors are overseeing the fund interests – but also verify and hold them accountable for their performance.
Kathleen Celoria is the Executive Director of DMS Offshore Investment Services (USA) Inc.