It was just 18 months ago that my colleague and I, whilst watching the French countryside rolling past the Paris to London Eurostar, discussed the idea of establishing our own business to provide independent directorships to offshore hedge funds. There were five factors that convinced us to take our idea forward:
Once we had taken our initial decision, we considered where we should be located. It seemed to us that, if we were to be directors of offshore hedge funds, we ought to be offshore, and the natural location was the Cayman Islands, where some 7,000 of the world's estimated 8,000 hedge funds are domiciled. Our target for starting the business was the end of December 2004, and after some preliminary planning we booked ourselves a week in Grand Cayman, on a flight departing London in September 2004, to firm up our plans. Unfortunately, Hurricane Ivan intervened, our flight was cancelled, and it was January this year when we flew out to discuss our plans with people on the island. The reactions we received were, without exception, highly positive and encouraging, with the end result that we opened for business last July, six months later than originally envisaged.
Currently, we are working with some 30 fund managers, providing directorships to the funds they manage, and are well on the way to reaching our estimated capacity, under our current business model, of working with 60 – 100 managers.
Background
One of the first questions I am asked when discussing our services with a fund manager is, invariably, "What do you do for the fees you charge?" (One London manager put it rather more waspishly, his comment being "I admire someone who reaches out with both hands to grasp a sinecure" – needless to say, I am not, at the present time, a director of any of the funds he manages!). So, what are the role and responsibilities of an independent director of an offshore hedge fund? Before answering that question, there are four areas worth examining:
The jurisdiction generally referred to in this article is the Cayman Islands, where law and regulation is based on that of the United Kingdom, but similar frameworks exist in other offshore jurisdictions where hedge funds are domiciled in any numbers.
Cayman Islands hedge funds are commonly formed and organised as mutual funds. Investors purchase shares in the fund, and management shares are usually issued to a fund management company. The management shares do not participate in the profits of the hedge fund, but enable the management company to administer its affairs.
With respect to the administration and operation of a hedge fund, outsourcing reaches a plateau that most other industries can only aspire to but seldom reach. Most hedge funds do not have any salaried staff; the day-to-day functions are outsourced to industry specialists, as can be evidencedby a quick glance at an offering document for a hedge fund. The outsourced functions include investment management, administration, custodianship, shareholder services, secretarial and registered office services. The hedge fund also appoints lawyers and auditors, an annual audit being one of the requirements of being a licensed entity. The end result of the outsourcing process is that the director of a hedge fund does not hold a full-time position.
Next, the law. Under Cayman Islands law a director owes two classes of duty:
A director's duties are owed to the company (i.e. the hedge fund) as a whole and not directly to the company's shareholders. In particular, a director appointed by a particular shareholder owes his duties to the company and not the shareholder. However, in some cases directors may also owe duties to the creditors of the company (almost certainly the case where there is insolvency).
Directors have a duty to act in good faith in the best interests of the company. In particular, a director must not agree to exercise his power in accordance with the instructions of a third party. A director must not put himself in a position which conflicts between his duty to the company and a duty to another person, including a shareholder whom a director represents on the board.
A director must inform himself about the affairs of the company and join with his co-directors in supervising and controlling its affairs. In the outsourced environment of hedge fund companies, directors need to supervise the activities of persons to whom they delegate their functions. For instance, as regards the investment manager, they need to ensure that the investments made are within the trading strategy described in the offering document. They also need to satisfy themselves that the methods of valuation of assets are adequate and accurate as can be, and should not rely solely on valuations provided by the investment manager.
The Cayman Islands, as befitting one of the world's largest offshore financial centres, has a strong regulatory framework, under the supervision of the Cayman Islands Monetary Authority (CIMA). CIMA has issued guidelines on the criteria it uses in determining whether persons are fit and proper to act as directors of hedge funds. The criteria, embedded in legislation, are:
With respect to honesty, integrity and reputation, CIMA makes detailed background checks into applicants' personal standing and business reputation. The checks include credit references and other checks to ensure the applicant is of good financial standing. When it comes to competence and capability, CIMA considers whether or not the person concerned has the technical knowledge and ability to fulfil the director's role, and looks for professional qualifications. In addition, CIMA looks for experience acquired through years of employment and positions held in determining fitness and propriety. CIMA also applies "fit and proper" assessment as both an initial test when considering an application for a business licence and as a continuing test for conduct of business.
Above we have a brief overview of a hedge fund director's responsibilities under the law, and the standards required by the regulators. There is one other topic, taxation, that should be mentioned before we delve into the more detailed responsibilities and functions carried out by an offshore hedge fund director.
Offshore hedge funds are domiciled in countries that do not impose any taxation on the funds themselves. However, if the affairs of a fund are not conducted offshore, it could be argued that the fund is tax residentin another country. In the UK, home to many of the world's top hedge fund managers, the basic rule is that an offshore company will be considered taxable in the UK if central management and control of the company is exercised in the UK.
Central management and control is not the same as the day-to-day running of a fund, which, as already observed, is generally outsourced. It is the strategic decision-making process, and includes responsibilities such as the setting and regular review of the investment polices and strategies of the fund, plus determining whether the fund should appoint a new investment manager. To avoid any UK taxability issues, it is important that the central management and control is vested in the board of directors, and that central management and control is genuinely exercised outside the UK.
The role and responsibilities of the board include the following:
There is no room in this article to consider all of these responsibilities in detail, and I commend an AIMA publication, 'AIMA's Offshore Alternative Fund Directors' Guide', released in June this year, which gives an excellent overview. However, some of the more important responsibilities are worthy of comment:
Review of investment performance is perhaps the most significant role of the fund's directors. The directors, even though they may be acting in a non-executive capacity, need the competence and skills to enable them to review the performance with an eye to style drift and adherence to risk parameters. The directors will rely heavily on information provided by the fund manager and the fund administrator, and the ability to evaluate the information in the context of the hedge fund industry is key.
Investment policy is the main driver of investment performance; the director needs to understand the investment policy of the fund as set out in the offering memorandum and to evaluate the investment strategy of the fund manager in the context of the policy. The director will need sufficient information from the fund manager and/or the fund administrator to understand how the investment performance was achieved. This can be a demanding task, given the emergence of increasingly complex trading strategies allied to the already complicated nature of the OTC derivatives that may underpin such strategies.
Monitoring the NAV of the fund is also an important responsibility of the directors, given that they are responsible in turn to the investors. Wrongly calculated NAVs may, if the errors are significant, lead to subscribing investors or redeeming investors being unfairly treated, and so it is good practice for the directors to satisfy themselves that there are satisfactory procedures in place to ensure accuracy of the calculation. It is usual for the calculation of the NAV to be delegated to an independent fund administrator, and the directors need to satisfy themselves that the administrator has adequate procedures, controls and systems to provide an accurate NAV
Pricing of the fund's investment portfolio by the administrator is another key area. Depending on the investment strategy of the fund manager, this process may be relatively straightforward. Obvious examples are exchange traded futures and options, plus foreign exchange, which have widely published prices for valuing a portfolio. However, the more complex the investment portfolio, the more difficult it is to arrive at valuation prices which enable an accurate NAV to be calculated. In such instances, the directors should ensure that the pricing policies are not only reasonable but are adequately documented and disclosed in the offering memorandum, and then adhered to by the administrator.
Anti-money laundering rules and regulations have grown in significance and importance over the past decade. The rules apply to a broad range of financial and commercial activities in many jurisdictions, and the offshore jurisdictions most commonly used for domiciling hedge funds have AML rules that must be observed and applied to investors in hedge funds. The directors need to ensure that they have a clear understanding of the AML requirements in the relevant jurisdiction, and then satisfy themselves that the fund manager and (where appropriate) the fund administrator have robust procedures in place to ensure the rules are adhered to.
The appointment of service providers possessing the experience and systems appropriate for the complexity of the structure and trading strategy of the fund is an important part of establishing and managing a successful hedge fund. Service providers include the administrator, auditor, custodian, prime broker and market counterparties. The directors should, with the support of the fund manager, review all of the providers on a regular basis, to ensure that the service is effective and correctly priced and that there are no conflicts of interest.
The information provided to investors is usually set out in the offering memorandum, and may include audited financial statements and monthly statements of the NAV and the investors' holding in the fund. The board of directors need to be alert to any delays on the part of the administrator in finalising and distributing information to investors, and should also review the information. Similar review procedures should be in place where the fund manager is providing fund performance information to investors.
A stock exchange listing means that the directors and the fund share the responsibility to ensure that the fund is in compliance with the stock exchange rules. Failures to comply can, if sufficiently serious and uncorrected, lead to the shares being de-listed by the exchange. The board of directors of the fund should be in a position to monitor compliance with stock exchange rules.
The issuance of side letters has become a feature of the institutionalisation of the hedge fund industry. Institutions such as funds of funds and pension fund managers commonly ask for special terms for their investments, which are laid out in side letters. The board of directors needs to review such letters carefully to ensure that the interests of all the investors in a fund are adequately protected. The risk posed by side letters is that some investors in a fund may get preferential treatment which could put other investors at a disadvantage. This particular issue also needs to be looked at in the context of stock exchange listing rules, especially in the case of a listed fund, to ensure that the issuance of the letter does not breach the rules.
As a closing comment, I believe it is important for an independent director to establish a strong working relationship with the fund manager (who often has a representative on the board of directors of the hedge fund). Following are two examples of such cooperation taken at random:
Firstly, when reviewing a prospectus earlier this year, I observed that one clause, intended to benefit certain investors, adversely impacted on others under certain circumstances (the law of unintended consequences). Because I was involved in the setting up of the hedge fund from the early stages, the anomaly was pointed out at the drafting stage and so eliminated from the final version.
Secondly, in the third quarter of this year, when Refco hit the headlines, I used my experience and background to support and assist a manager in drafting up netting agreements for the good of the investors in the funds he managed.
Although the interests of independent directors and fund managers are not perfectly aligned (and nor should they be), it is in the interests of the investors in the fund that they work together as closely as possible for the benefit of the hedge fund. An independent director who is prepared to take on the role and responsibilities adds value to the fund, for the benefit of the investors, and provides support for the manager.
A.R.C. Directors Ltd provides independent directorships to the international hedge fund community. The company is managed in the Cayman Islands by its owners, Alan Tooker and Ramona Bowry, who together have amassed more than 30 years of experience in the alternative investment industry.