Corporate Governance
Who would be a hedge fund director these days?
Paul Scrivener of Solomon Harris considers the increasing corporate governance demands on hedge fund directors.
Being a director of a hedge fund is a business in its own right these days. In the offshore world an increasing number of institutions and individuals are coming forward to offer their skills and expertise as directors to fund managers as the corporate governance demand for independent directors on the boards of hedge funds grows. This is certainly the case in the Cayman Islands where fund managers have a great deal of choice in appointing directors ranging from corporate groups who hire out senior staff to serve on hedge fund boards to single individuals with significant experience in the hedge fund industry.
However, these days being a director of a hedge fund is certainly not for the faint hearted. Both the law and industry practice place significant corporate governance responsibilities on a director and a director ignores those responsibilities at his peril. A large number of directors sit on many hedge fund boards and as the world becomes ever more litigious, the risk of a director becoming embroiled in court action inevitably increases. However, for the director who has the requisite expertise and properly understands his responsibilities, the risk of personal liability should be slim. Like any other business role, it is a case of adhering to appropriate risk management principles.
There are certain features of being a hedge fund director which are very different from being a director of a regular onshore company, say, a manufacturing or retail company. These features have a direct bearing on the corporate governance requirements. One of the most important features is that usually a hedge fund has no employees, no executive directors and no premises. By executive directors, we mean full-time working directors engaged under an employment contract. The terms of appointment of a hedge fund director will invariably reflect that the role is a part time one and the remuneration will also reflect that situation. Another feature is that the directors’ role will be one of oversight rather than of day to day management responsibility.
How can a hedge fund function without employees and without executive directors? It functions through delegation of all its operations to service providers. Frequently, day to day management and trading are in the hands of an investment manager, accounting, net asset value determination and the processing of subscriptions and redemptions are dealt with by an administrator and clearance and settlement of trades are handled by a broker. In many respects the operation of a hedge fund is outsourcing taken to the ultimate level with typically no day to day work being handled “in-house”. Such a structuring is cost effective and efficient. Contemplate the infrastructure that a hedge fund would need in order to carry out each of these operational activities internally.
If all the day to day activities have been delegated, does that mean that there is nothing left for the directors to do and the concept of corporate governance largely an irrelevance in the hedge fund world? That is certainly not the case and any hedge fund or hedge fund director who feels it is, is on a dangerous path. At this stage in the corporate governance developments for hedge funds, there are no legally binding codes of conduct which dictate how boards should function (that will surely come) but there are well developed rules under the general law.
The law makes it very clear that, subject to the company’s constitutional documents, directors are perfectly entitled to delegate and indeed, as it was said in one English case, business could not operate without the ability of the directors to delegate. However, what the law does not permit is abdication of responsibility. In other words, having delegated a particular task or function, the directors cannot simply walk away but instead they retain a residual responsibility of oversight. This residual responsibility flows from the directors’ overriding fiduciary duty under the law to act in good faith and in the best interests of the company. This duty is owed to the company itself and not to any individual shareholder. If a Cayman court were ultimately to decide that a director had breached this duty and the company had suffered financial loss as a result, a director may be held personally liable for that loss. A salutary thought for any director! However, it is important to remember that it is not the role of the court to second guess business decisions made by directors and a court would only make a finding of breach of this fiduciary duty where it took the view that no reasonable man could have considered the particular decision at the relevant time to have been made in good faith and in the best interests of the company.
Directors are also required to act with care and skill and, again, failure to do so can lead to personal liability. As yet, the Cayman courts have not had to consider this particular duty but, whilst the issue is not free from doubt, it is likely that they would follow English judicial authority.
This has been a developing area of law in England over the past eighty years or so and it is fair to say that the bar stands quite a lot higher these days. The test of care and skill enunciated in the 1925 landmark case of Re: City Equitable Fire Insurance Co was the care which an ordinary man might be expected to take in looking after his own affairs subject to the fact that a director could not be expected, in carrying out his duties, to exercise a greater degree of knowledge and experience than he actually had. The bar was therefore set relatively low at that time – a director who was a well-meaning amateur was acceptable.
Subsequent cases have had the effect of raising the bar culminating in the 1994 English case of Re D’Jan of London Ltd where the test of care and skill was said to be that of “a reasonably diligent person having both (a) the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as are carried out by that director in relation to the company and (b) the general knowledge, skill and experience that that director has.” This is therefore a dual test ie objective with regard to the role carried out by the director and subjective with regard to his or her own knowledge, skill and experience. Applying this to a hedge fund director with, say, a legal background where there were allegations of breaches of law by the fund, that director would be held to a higher standard of care and skill than a director with no legal background. The courts have also made it clear that whilst the duty of care and skill is of universal application to the directors of all companies, how the duty is applied depends very much on the particular circumstances and the role that a given director fulfils. Therefore, the expectations of the chief executive of an onshore manufacturing company are likely to be very different from those of a non-executive director of a hedge fund. Hence, corporate governance principles always have to be moulded to the given circumstances and one size certainly does not fit all.
It is obviously somewhat dangerous to try and state general principles but typically what would the oversight responsibilities of a hedge fund director encompass? During the set up of the fund, a director is likely to have a reasonable level of involvement, in particular, with the review of the offering memorandum. Once the fund has been set up, the role will be more intermittent involving such matters as a high level review of the periodic net asset value determination produced by the administrator, consideration of investor reports sent out by the investment manager, dealing with one off issues such as late subscriptions or redemption requests and assisting in the finalisation of the fund’s audited financial statements.
The involvement will be at a high level reflecting that the role is one of oversight and, unless the directors become aware of a specific problem, they will not usually involve themselves in the details of the fund’s day to day trading carried out by the investment manager or in the minutia of the accounting work being undertaken by the administrator. However, their oversight role will involve the directors in keeping the performance of all service providers (in particular, the investment manager and the administrator) under periodic review (typically annually) and the directors should not be slow to criticise any poor performance and, where circumstances require it, to remove a service provider.
There are no hard and fast rules as to the frequency with which board meetings must be held. The legal requirement is that board meetings must be held as often as necessary to enable the directors to fulfil their duties and therefore the frequency of board meetings will very much depend on the particular fund and the size of its board.
Of course, it is inevitable that from time to time during the life of any fund, issues will arise and some of those issues may be major or even critical. Examples would include allegations of impropriety by the investment manager, a significant down-turn in performance and substantial redemptions. It is at these points of crisis that the role of the directors is crucial and they must be able to rise to the challenge and bring their knowledge and experience to bear to steady the ship as necessary.
There is no doubt that the role of a hedge fund director these days is a challenging one and it seems likely there will be a shake out of the market in the coming years as the corporate governance requirements on hedge fund boards inevitably increase. However, those directors that remain will be able to bring true added value to hedge funds in a way that would not have been contemplated only a few years ago.
Paul Scrivener is joint head of the investment funds group at Cayman Islands commercial law firm, Solomon Harris. Click here to email Paul.