Improving Investor Protection

Redefining the role of the non-executive director

Originally published in the December 2010 issue

The hedge fund industry has experienced major changes over the last 20 years. What was once a secretive backwater of the financial world is now mainstream. An investor base of high net worth individuals, making decisions about their family wealth, has been joined by pension funds, insurance companies, endowments and other large institutional investors. Hedge funds have obviously welcomed the huge inflows of capital and have altered their business models to meet the more stringent compliance and governance requirements of institutions. However, as has become increasingly clear to investors through a number of high profile blow-ups, there is at least one legacy area where hedge funds have not meaningfully improved their standards, leaving an important weakness in the service provided. This weakness is the role of the non-executive director.

Hedge fund investors are being poorly served by offshore boards that are frequently under-qualified, over-stretched and not sufficiently independent from the influence of the fund manager. As a consequence, this internal watchdog has come to be regarded by both investors and regulators as essentially toothless. This article reviews the responsibilities of the non-executive director, examines the alternative approaches to filling this position and suggests improvements that can upgrade this governance role and offer investors a higher standard of protection.

Duties of non-executive director
An offshore fund, structured as a limited company, will typically be run by a board of non-executive directors. This board is charged with managing the fund’s affairs through its relationship with a series of service providers, most important of which is the fund manager. The fund’s directors accept a responsibility to supervise the activities of the business and they have a duty of care to the company and, by extension, also to its shareholders.

Usually, the director’s role is focused on high level oversight ensuring that on a day-to-day basis, the fund is properly structured, legally compliant and delivering a satisfactory level of service to its shareholders. However, on occasion, such as when disputes arise, the directors are required to step in and ensure that the interests of all shareholders are being protected. Essentially, the non-executive director should be an important internal safeguard, ensuring that the fund manager does not have a completely free hand with investors’ capital.

Qualifications for the role
There are no formal qualifications to becoming a non-executive director, beyond completing due diligence questionnaires by the offshore regulators, a residency requirement in some jurisdictions and limited restrictions by listing exchanges. However, there are guidelines which have been compiled by various industry bodies and regulators, as to the appropriate levels of expertise and independence within the board.

However, despite the guidelines, non-executive directors have historically been drawn mainly from the pool of offshore service providers who, while competent in the fields of administration, custody and investment law, typically do not provide any depth of actual investment experience. The fund manager is therefore being supervised by a conflicted and incomplete board, lacking the skillset to actually understand what is going on within the portfolio. To compound the problem, offshore directors have frequently taken on large portfolios of directorships, sometimes hundreds of funds, leaving themselves insufficient time to dedicate to the issues of any one. In practically every fund collapse to date, the offshore directors have missed the danger signals and provided no advance warning to investors.

Background to the role
Historically, offshore directors have usually been handed the roles by default rather than being actively chosen by the fund manager. At launch, the new hedge fund manager chooses a domestic lawyer and prime broker, who assist him in selecting a domicile, an offshore lawyer and an administrator. The offshore board is then constructed, primarily of individuals drawn from these offshore counterparties. The hedge fund manager treats the offshore directors as a necessary inconvenience and is happy to pay the lowest price for minimal oversight. The offshore lawyers and administrators treat the role as a perk of the job and see no problem in becoming board members on large numbers of funds.

The board of directors, supposedly looking after investors’ interests, is then composed of individuals drawn from firms whose business depends wholly on the fund manager. As such, in addition to lacking an investment skillset, they usually have insufficient motivation to disagree with or challenge the manager, or to report any misgivings to the investors. Where hedge fund blow-ups have occurred, there have been few repercussions for these roving non-executive directors, they simply lose a small portion of their income and move on to the next board.

Active director selection
In some cases, the hedge fund managers have not simply accepted the directors handed to them by the service providers, but have actively sourced their own directors who they feel can better represent the fund. While this would seem, on the face of it, to be a superior solution, in practice the level of oversight and protection afforded to investors is often not meaningfully better.

Given the absence of an obvious pool of independent candidates, when hedge funds select their own non-executive directors they often turn to one of two main sources: ex-colleagues from the financial sector or captains of industry. Both of these are effectively references on the character or expertise of the fund manager rather than sources of critical ongoing oversight of the fund.

Due diligence
In the wake of the Madoff case and the financial crisis, investors have tightened up on the areas of compliance and governance. The increasing popularity of UCITS hedge funds testifies to the demand for better transparency and liquidity from the investment community.

A study of over 200 funds of funds conducted in June 2010 by Jason Scharfman of Corgentum Consulting examined the importance they placed on various aspects of operational due diligence. One of the key conclusions of the study was that the role of the board of directors of offshore funds is dangerously minimized with less than 2% of investors covering these items during due diligence.

The evidence suggests that, even now in the wake of high profile fund blow-ups, directors rarely receive phone calls from prospective investors to confirm their identities, directorship histories or qualifications for the role. The obvious conclusion is that investors continue to regard the non-executive director as an irrelevance.

Directorship services
The largest recent change to the provision of non-executive directors is that the offshore administrators are now more reluctant to fill this role. Instead we have seen the emergence of specialist firms who provide hedge funds with offshore directors.

Usually these firms are effectively spin-offs of the administrators, staffed by individuals who would have previously occupied the directorship roles in-house. On the plus side, they are more independent of manager influence and often have strong back-grounds in fund compliance, audit, accounting and administration – all important elements of fund governance. However, as with the offshore law firms, the other main supplier of director candidates, the specialist firms supplying directors lack expertise in portfolio management. In addition, they often serve on the boards of hundreds of funds, in some cases refusing to disclose how many directorships they hold.

This level of service continues to demonstrate the old industry mindset where hedge fund directors are seen as a necessary inconvenience. The director is not regarded as a key safeguard of investors’ interests, but a back-office functionary whose role is to process as many funds as quickly as possible through the system.

If the alternative investment industry is to meet institutional governance standards over the next 20 years, this mindset must change. Directors should be there to serve and protect the company and its shareholders. The board should act as a check and balance against the influence of the fund manager. Handing off this responsibility to junior staff and IT systems is not adequate governance performance.

A practical solution
The practice of large scale multiple directorships should be reviewed. This is a hang-over from a previous age and reflects badly on the modern hedge fund industry. A full-time director, with resources at his disposal, can possibly make a case for being on tens of boards, but not hundreds. Investors need to conduct more thorough due diligence on the identities and workloads of offshore directors and insist that every director has the time at his disposal to properly oversee their investments.

Reference checking
Institutional investors have a duty of care to their own investors when considering the offshore board. The Financial Reporting Council’s Stewardship Code urges them to ensure that “board and committee structures are effective, and that independent directors provide adequate oversight.”

Investors should be fully aware of who the offshore directors are, what experience they possess and what their directorship history is. Individuals who have demonstrated obvious failures of their duty in the past should be namedand shamed. There have been calls for the various offshore regulators to establish public databases of hedge fund directors, listing their current and previous roles. This idea should be encouraged.

Investment experience
Within the make-up of most boards, the most obvious omission is the lack of alternative investment experience. While directors with administrative and legal backgrounds bring important experience to the table, the effective governance of the fund has to be seriously comprised if none of the directors has knowledge of the underlying investment strategy.

Investors should have the comfort of knowing that an experienced asset manager is part of the team monitoring the fund’s activities on their behalf. The individual should have proven experience in the field and a reputation to protect. They should have sufficient time to devote to each fund and have the character to challenge the fund manager, and other service providers, when necessary.

Sourcing talent
Part of the reason for the status quo is the absence of suitable candidates for directorship roles. Progressive hedge funds often struggle to find offshore directors of sufficient caliber who demonstrate high standards of governance. The reason for this is that there are few obvious points of access for new entrants. The main providers of offshore directors are reluctant to give up roles that they have historically seen as a perk, especially when doing so reveals the weaknesses in their service.

Potential new directors from the hedge fund industry therefore need to be encouraged and have paths opened to them. This could be done through the establishment of public lists of independent directorship candidates held by the prime brokers, lawyers or industry bodies. Alternatively, the funds could be encouraged to pay sourcing fees and the recruitment industry play a bigger part in filling these roles.

Location & taxation
For reasons of convenience, boards have a tendency to be comprised of individuals based in the same jurisdiction as the fund, even when there is no regulatory requirement to do so. Provided that offshore and listing regulations are met, and the majority of the board is in different jurisdictions to the fund manager, then domestic taxation needn’t be problematic. Given recent cases where the US bankruptcy courts have found no offshore centre of main interest even with resident Cayman directors, there is an argument that the typical offshore board needs to strengthen its case that the mind of management is overseas, regarding taxation.

For a fund to be considered offshore by the UK or US taxation authorities, it needs to show the fund is not just a brass plaque entity, but that central management and control are genuinely exercised offshore. If the fund has a majority of independent directors with credibility and appropriate experience, then the argument that the board has real discretion is made much more convincingly, than if the board is staffed by service provider directors, who risk the perception that they are merely rubber-stamping the fund manager’s decisions.

The main issue is that directors with alternative investment experience cannot be found in sufficient numbers in the tax-haven jurisdictions. Therefore, if funds want access to this talent, they need to become more flexible when constructing their boards, and not just take the laziest option.

Director fees
Director fees are not standardised and can range from under $10,000 per annum to $30,000 per annum or more, with an average of around $15,000.However these fees are paid by the fund, hence it is the investors who ultimately have to bear this cost, and who should decide what represents value for money. Given that even this wide variation in fees, when split across a pool of investors, probably works out at a difference of only a few hundred dollars each per annum, then within reason investors might be less concerned about the fee variation and more concerned about how much oversight they are actually getting for their money.

Investor pressure
None of these proposed improvements will occur without pressure from the investment community. With the exception of an enlightened few, most hedge funds will choose to opt for less supervision rather than more. The onus is therefore on investors to make it clear that historic low levels of service are no longer acceptable. They need to conduct more thorough due diligence on the identities of offshore directors and not merely tick a box to confirm their “independence”.

The duty of care owed to the end-investor demands that investments don’t go to funds with inadequate standards of oversight. This is particularly the case for pension funds where the ultimate investor is the general public. It is not reasonable that stringent governance standards are applied to traditional portfolios, but not to alternative ones.

Despite apparent improvements, offshore non-executive directors continue to provide insufficient oversight of the hedge fund manager and an important internal safeguard is not being properly applied. Tightening regulation is a clear sign that the regulatory authorities no longer trust the alternative industry to police itself. Standards of self-governance need to improve if this trend is not to follow a course where the investment freedom that enables hedge funds to succeed becomes ultimately regulated out of existence. This industry has however always attracted the brightest and the best, and the challenge of overcoming the legacy of directorship “light” is not beyond our abilities.

Kevin Ryan has been researching and investing in hedge funds since 1994. He was a founding employee of Financial Risk Management and subsequently managed hedge fund portfolios with Liberty Ermitage and ABN AMRO, where he was head of research. He is currently a consultant for Asian Alpha Ltd and the founder of HedgeDirector, a specialist provider of independent directors.