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Continuing Professional Development Course for Directors of Investment Companies and Investment Funds
The following is a presentation I gave on Monday 16th February at the “Continuing Professional Development Course for Directors of Investment Companies and Investment Funds”, held in Malta, organised by the Directors Chambers and sponsored by the MFSA (Malta Financial Services Authority). The text represents my own personal opinions and thoughts and is not necessarily those of TMF Custom House Fund Services (Ireland) Ltd.
Good morning ladies and gentlemen
We are here today to discuss the role of directors of funds in the context of governance – or perhaps the role of governance in the context of fund directorships.
Either way there has been a surge in interest in fund governance and particularly since both the Madoff and Weavering scandals. The Madoff scandal attracted attention to all aspects of fund governance, whereas the Weavering scandal really concentrated the mind on the role of directors and the board of fund companies. I think it is fair to say that many people seem to believe that the whole area of fund governance is a relatively new topic, especially in the area of directors responsibilities. Of course this is poppycock. The subject of director’s duties and responsibilities has been on the table for many years.
I was Deputy Chairman of AIMA, which is the Alternative Investment Management Association, from 2002-2008. During that time I was also Chairman of AIMA’s Sound Practices Committee, which was responsible for producing a range of guides including a series of Guides for Sound Practices for many participants in the industry, including:
Hedge Fund Managers;
Funds of Funds Managers;
Hedge Fund Administrators;
Business Continuity and Management for Hedge Fund Managers;
Guide to Sound Practice for Hedge Fund Valuations; as well as
Guidance re Market Ethics; and
a range of generic due diligence questionnaires (DDQs) for hedge fund managers and investors selecting service providers, such as Administrators and Prime Brokers, and investors selecting hedge fund and fund of funds managers and CTAs. At the time some people expressed doubts as to the use of these DDQs, but I think it is fair to say that because they were very comprehensive they have become the basis for due diligence globally.
Indeed today some of the biggest hedge funds around, including Bridgewater, use the AIMA due diligence template for their own DDQs.
But more importantly, in the context of our discussion today, AIMA also produced a Guide for Alternative Fund Directors, which was originally published in 2005, with a second edition issued in 2008. Frankly there is little that needs to be added to these Guides as they are pretty comprehensive, although naturally new things come up from time to time.
Despite the fact that at the end of last week the original Weavering (2011) judgment, which awarded US$111 million against the two “independent directors ” (although how the two directors, who were the investment manager’s step-father and brother, could be described as independent is beyond me) – anyway that award was thrown out by the Cayman Appeals Court, it is a fact that the Weavering case concentrated the minds of fund directors and, for that matter, investors, when everyone started jumping up and down because of the weight and extent of the Cayman judge’s ruling and it was not just the astronomical fine but also his criticism of the board of directors of the fund. At that time I called Iain Cullen of Simmons and Simmons, who many of you will know and who co-sponsored the Directors Guide with Custom House. I asked him if I was right in my opinion that there was nothing earth shattering in the judgement and the description of Directors Duties and Responsibilities that was not covered in the AIMA Guides. Iain agreed with me.
My point is not to boast that we at AIMA had done a superb job; (although that is true) my point is that Weavering changed the attitude of many directors, who all of a sudden seemed to recognise not only their duties and responsibilities, but also that there could be some very Draconian penalties if the directors did not do their job properly. So Weavering did not result in the introduction of governance for directors, it merely resulted in some directors – hopefully most – recognising that they had duties and responsibilities and it would be dangerous not to follow them.
The appeals court’s decision, which was only published last Friday and which I have not had time to study in any depth, appears to me to be based on that tricky task of defining “willful neglect” combined with the great get out of jail card, represented by the directors’ indemnity provided to the directors by the fund. These indemnities are valid unless the directors are guilty of that “willful neglect”. I often wonder if the lawyer who first came up with that term ever knew of the confusion and oodles of legal fees that it would generate for ever more. Anyway the appeals court decided that the directors of Weavering were indemnified and therefor did not have to pay the trunkful of dollars.
I think it is worth stressing that the Appeals court did not exonerate the directors who were both guilty of doing absolutely nothing during their tenure on the board, but blissfully ignored their duties and responsibilities .So I suggest that no independent fund director take any comfort from last Friday’s news from the Caymans, but rather remain cautious and aware of the conclusions that the Judge came to in the 2011 judgment It was put very well in the report of the appeal that I read on Saturday from the Cayman lawyers, Solomon Harris , who made the point that, whilst “they do not have to pay US$111 million, their reputations remain in shreds”. And what is an independent director in our industry if he does not have his reputation?
Having said all that it is not only directors who were reacting to Weavering. Investors have also started to take the duties of directors seriously and by investors I am referring mainly to institutional investors. Of course some institutional investors have taken this very seriously for many years, but it is only fairly recently that the importance of carrying out in-depth due diligence on the directors of funds that they wish to invest in has been prioritised by many investors. These investors – and I have no doubt some are here today – tended to concentrate their efforts on the Cayman Islands because that is where the majority of American managers have established their offshore funds. And it has to be said that both the Weavering judgement and the efforts of these investors has had a noticeable effect in that jurisdiction.
I think this is the appropriate moment to blow another trumpet. I have been asked to take on the chairmanship of a new not-for-profit organisation called “The Fund Governance Association (FGA)”. This is one organisation that proposes to do what it says on the tin. The idea is to persuade both the directors of and the investors in hedge funds to take a more active approach and attitude to fund governance. You will hear more about the FGA from Simon Osborn this afternoon so I will limit my comments to the primary objectives of this organisation.
Firstly, we propose to establish an alternative fund directors directory. This will be a purely voluntary source and those who are prepared to enter the list will do so on a “comply or explain” basis in terms of answering all the questions that will be asked on what will be something like a detailed N-Q for the Directors. The idea is twofold in that prospective or indeed existing investors in funds will be able to look at the directory and hopefully see the names of the directors of the funds that they are interested in. Furthermore managers who are looking to establish a fund and appoint independent directors will be able to review the list and see if there is anybody there that appeals to them for various reasons.
Ironically CIMA, the Cayman Island Regulatory Authority, has discussed the possibility of establishing a directory of Cayman Island Directors, but, following local consultation, that appears to have been shot down for the immediate future at least. The FGA directive is intended to be global and will, we hope, attract qualified and experienced potential and existing fund directors from a wide variety of jurisdictions.
Secondly, we are going to encourage those investors, who are presently standing on the sidelines, to follow the path of their more active brethren and themselves be pro-active to the governance of directors rather than reactive.
Thirdly, although this won’t happen initially, we want to persuade the US hedge fund industry to step up to the plate. Historically fund governance has been way down the list of priorities in the US and in a very recent edition of the NED (the Non-Executive Director) journal there was a report that many US attorneys had told the interviewer that most of their fund clients, i.e. managers, believed that offshore fund directors did little to help either the manager or the fund. In my somewhat cynical way, I suspect and frankly hope that historically many US managers believed that any director of an offshore fund who thought for himself and wasn’t a puppet of the manager was an interfering nuisance. But although that is changing, I believe to some extent that attitude remains today. Whether I am right or wrong, the attitude to the non-executive director of offshore funds must change in the United States. Furthermore the US has a major task in creating and effecting a governance structure for the governing bodies of the classic US limited partnerships – the typical hedge fund structure in the US – where often the general partner is the investment manager – that is surely “Conflict” writ in Christmas lights.
Having said all that, I do not propose to outline the duties and responsibilities of directors, I have no doubt that will be done very efficiently by many of the speakers who you will hearing for the rest of the day. Furthermore as I have already said, there is a plethora of material available that an existing or potential fund director can study, including as well as the AIMA Guides, publications by the MFSA, who have so generously sponsored this event, and CIMA – the Cayman Regulator – and other organisations. So what I propose to do is make some personal observations which I feel need to be thought about by both boards as a whole and individual directors.
Firstly it is a fact that the board of directors of a fund company has a primary duty and obligation to service the fund company. By derivation, those directors therefore have a duty to look after the investors in the fund. I think it is incumbent on all of us to remember why most investors have invested in any fund and that is to be somewhat simplistic, usually a combination of capital protection and capital growth – how much protection and how much growth will be dependent upon the strategy and the successful application of that strategy.
In today’s regulatory environment, which has a tendency to smother us all, the board and indeed individual directors spend what some believe to be an inordinate amount of time discussing and ensuring compliance by all service providers to the fund with the flood of new regulation that is coming down the pike and it looks as if that flood is nowhere near abating. In my opinion, too great a proportion of board meetings is spent on regulatory oversight and compliance with those regulations and too small a portion of time is spent on understanding and reviewing the investment strategy and the performance of the investment manager. Please don’t think I am suggesting that the amount of time spent on regulatory compliance should be cut, I just think that more time should be spent on the investment strategy and performance. To be clear I think that at least a 1/3 of the board meeting should be covering the investment and different aspects of the investment process and its success as demonstrated by the fund’s performance.
I sit on the board of several funds where the board visits either the offices of the investment manager for a day’s review of everything the investment manager is doing and how it operates, etc. and on other funds where we visit the areas in which they invest. This ranges from the US to Latin America and even Africa. Obviously these are large funds because it is expensive to transport a board several thousand miles and then put them up for 2 to 5 days, but nevertheless it is an attitude that I applaud and I think that, as funds grow, the board should consider this. All of this and the regulation means that the directors of a fund are taking on more liability which I will refer to later. One may or may not applaud the Americans ability to export Coca Cola, hotdogs and Dell computers, it is a sad fact that they have also exported the culture of litigation. As a result, if for any reason whatsoever a fund loses money and there is any query about the reason for that loss, then it is likely that one or more investors will sue the person they deem responsible. But American litigation culture has also encouraged such litigants to sue everybody else, concentrating initially on those with deep pockets which may just imply they are insured and otherwise on everybody within range including the directors. Of course this justifies the requirement, which is now regulatory, as well as logical, that boards of funds should have appropriate insurance. The cost of that insurance is high, because the sums to be covered must be high. Even for a small fund, I think it is pointless having insurance of less than $1 million and if you have that cover I think it should be recognised that if there is a claim that most of that will be spent on legal fees, whether or not there is a valid case against the board.
The knock on effect of this is that many potential directors don’t want the hassle. Appropriately experienced and knowledgeable directors will almost, inevitably, be older and indeed near retirement. If they have suitable knowledge and experience they have probably amassed a certain amount of capital – their nest egg. Why should they put that and, equally important their hard won reputation at risk for what is, and here is the nub, a relatively small, indeed in some cases, insignificant directors fee.
The point I am making is that as the regulatory environment becomes more intrusive so the liability on directors becomes greater and the number of directors who are prepared to take the risk diminishes.
Getting back to the compliance duties of the board, I think there has been a great improvement in the involvement of directors in hedge funds, but nevertheless there is still the danger that directors will merely “tick the box” when reviewing compliance issues. This reminds me of a story which may be apocryphal, but which I understand is accurate and which I hope you will forgive me telling you as I am wandering out of funds area into the banking area. I was told the other day, by a very reliable source that, in 2008, or thereabouts, but before the crisis, the Royal Bank of Scotland, received great recognition and indeed, I think an award, for their compliance policy and the implementation of that policy. This is of course extraordinary in light of what subsequently came out of the woodwork, but what it illustrates is that their compliance rating was probably largely based, if not entirely based, on ticking boxes and not on actually digging down to see whether the implication of the boxes they ticked was as accurate at they believed.
What I conclude from this is that it is essential that directors do more than just tick the boxes. For example, the board should, at least once a year, visit the service providers or get the service providers to come into a board meeting and interrogate them deeply to find out whether they are in fact doing what they say they are doing. Do not rely on their reports. I remember, at the time of Madoff, reading that there is a standard in the United States requiring auditors to look at financial statements provided by companies, with “an appropriate amount of cynicism” and I think that is a rule that directors of funds should follow.
Another area at which regulators have begun to take a closer look is what is described as the “Capacity” of the directors. I accept that this is an important area to review and I agree with the contention that it is difficult to believe directors with a huge number of directorships can always be doing a good job in fulfilling their obligations. Having said that, I am not sure that the knee jerk reaction to simply limit the number of boards that each director can sit on is effective, logical or fair. It goes without saying that the amount of time required by the board for satisfactory oversight and management of a closed ended fund, the assets of which are invested in a fully disclosed and transparent fixed term swap, is very much less than the time required by a director of a several billion dollar fund of funds, with a couple of dozen sub funds investing in a diversity of strategies and sectors.
At risk of sounding partisan, I much prefer the Irish Regulator’s approach which is two fold:
Firstly they ask how much time each director needs to fulfil his obligations on each board that he sits. That will dictate how many funds the director can sit on;
Secondly, the board as a whole is required to consider and confirm not only that each member devotes enough time to carry out their duties satisfactorily but also that the performance of each director is of the standard expected.
Other things investors are now looking for, and therefore a manager should consider when they are creating their board include, interalia:
- There should be at least 2 independent directors on the board, although some push for a majority-however I think more importantly;
- The independent directors should, between them, have a diverse range of skills and experience including an understanding of the regulatory environment, the investment strategy and the specialities of the service providers. All this is logical but almost certainly going to create its own knock on problems;
- Firstly it is unlikely that there are enough “qualified directors” who can meet the criteria of diversity, knowledge and experience and, as I have already said, are willing to take on the liability; and
- Secondly, if the number of directorships that an individual holds is limited then fees must rise – that is just the law of supply and demand.
It is worth noting that the judge in the Weavering case did make the point that the board were not paid any fees and he concluded (although he never used the words) that “if you pay peanuts you will get monkeys”.
Finally I attended a very interesting presentation last Thursday at Ernst & Young’s office in Dublin. The presentation was given by the Head of Enforcement at the Central Bank of Ireland, a very switched on lady barrister and at one point she referred to the recommendation that you should look at the behaviour of directors and by implication their attitude and the culture. I think there are signs and this is encouraging, that the culture is changing. By way of illustration, this lady referred to the fact that she had been born and brought up in Mayo, in the West of Ireland, at a time when she said that drink driving was an acceptable form of behaviour. She remembered that sometimes she was frightened to get in the car with somebody who had been drinking. However, peer pressure was such that she was equally frightened not to get in the car.
She then moved to England and lived there for 15 years, but on her return she found that someone who had been drinking and had got into the driving seat of a car was a pariah. The law hadn’t changed – although the application of the law might have been a little more effective. What had changed was the attitude and therefore the culture. After the presentation I mentioned to her that I thought that was a very good analogy and that that had also occurred in terms of fund directors attitude to governance. At her early morning, breakfast presentation there were somewhere between 75 and 80 people attending, of which I suspect 60 were non-executive directors. Obviously I couldn’t prove it, but I nevertheless suggested that 5 years ago she would have been lucky to have an audience of 25 people. We both agreed that showed a seismic shift in the culture towards the regulation, governance and compliance by non-executive directors. But there is nothing to be complacent about – the culture has slightly changed, but there is still a long way to go – et ergo the establishment of the FGA.