Investor protection and the focus on governance: from a slow start to the centre of attention
In the face of the continuous growth of assets and investment management over the coming years, no stone remains unturned and now even the world of governance is getting exciting. With or without the Paradise Papers exposé, regulators internationally are looking into how investment governance can be strengthened, as investors and creditors strengthen their due diligence efforts. IOSCO, the international body that brings together the world’s securities regulators, and the standard setter for the securities sector, has already, over 10 years ago, documented that their regulatory focus is on investor protection. We have increasingly seen that national regulators are actively pursuing this agenda, with implicit or explicit coordination through, for example, the European Securities and Markets Authority (ESMA), as well as other bodies and bilaterally. New but untested regulatory developments have been, and are now, reshaping the investment industry as we know it, and the end of that is not in sight. As regulators exercise their supervisory role, some of them may like to think that non-executive directors of collective investment vehicles (funds for short) may be their representatives at the very spot where the investment rubber meets the road, namely portfolio management and trade execution, given that fund directors oversee the operation of the fund. What needs to be remembered however, is that the concept of corporate governance – a set of mechanisms, processes and relations by which corporations are controlled and directed – only partly and quite differently applies to the typical fund management setting. While a fund vehicle is a legal entity aimed at holding investments and liabilities, having its own board of non-executive directors, it is by no means an integrated firm with sales, production, research- and other departments. As a result, overseeing fund structures may prove more demanding than overseeing integrated corporate structures, and typical agency solutions may fall short in the fund setting. Of course, the board should be composed such that complementary skills and experience are present. The fund vehicle does not have its own staff, which a board of directors can hire or fire, and contracts all functions out to service providers, such as a fund administrator, a custodian bank, a transfer agent, external legal counsel, and others, and of course with the main function of investment management contracted out to an investment manager: the service provider with the most power and the highest economic interest in running the fund well in terms of investment performance and asset size. In practice, fund directors have indirect influence only.
The impact of asymmetry in the investment construct and the quest for independence
It is well-documented that there is a large degree of asymmetry between investment managers, which depend on management and similar fees, and investors, who pay these fees, especially when legal documents at launch or the revisions of the fund are drafted, a further regulatory effort for alignment of these two constituents can be expected, one that will include transparency of fee calculation, of performance calculation versus a relevant benchmark, and of risk of losses in monetary terms, not just in terms of standard deviation. A further feature of this asymmetry is that in fact, given the operating relationship, it is the investment manager that monitors service providers for performance, quality and efficiency while potentially having various other roles in the investment setup, such as fund board director (classified as dependent), product launcher, co-investor and maybe others, potentially causing agency conflicts. This is especially noteworthy as investors can ask for their invested money back and redeem, implying potential instability in investment managers’ discretion over invested funds, a feature notably absent from regular (consumer) products. Clients redeeming can lead to a nightmare scenario for the fund, remaining investors and the investment manager, as we know from crisis times.
This outsourced setup of the fund vehicle, its board of directors and the service providers, in short the investment construct, has noteworthy implications for the concept of governance and a regulator would need to recognise this and manage accordingly. First and foremost: what can regulators and investors require from a fund board: the board, a collective of fiduciaries motivated by the interest of the fund, must need to take their fiduciary duty seriously and, as a collective, discharge their responsibilities by professionally overseeing the investment construct. Important to note, and as an attempt to speak in the spirit of Tamar Frankel, is that a fiduciary can be seen as someone who is trusted by others, fund investors in this case, because he or she has superior knowledge and expertise. This is of course often the case, but there may be cases in which this carries even more weight such as health and wealth. In that sense, fiduciaries have power and responsibility over those who trust them. This then means that fiduciaries can’t abuse the relationship of trust as the relationship is meant to satisfy only the needs of the investor.
Good practice says that the board should be in majority independent and all directors should be able to pass judgement independently. This independence implies at best that external non-executive directors should have no conflicts of interest or duties; even the appearance of those can lead to loss of trust, which, as we know, can lead to uncompensated illiquidity, withdrawal of investors’ funds and loss of value, let alone contagion. Examples of conflicts of interest or duties include: a director who serves on both the asset manager and the fund can be seen as conflicted, given conflicting organisational loyalties required, which may feed into incentive structures. Also, a director which also serves in the role of a service provider, such as external legal counsel, employee of a management company or others may be seen as conflicted, further, directors who themselves have one-off or on-going reciprocal business with service providers to the fund, may find themselves conflicted. Incentive schemes for directors would need to be taken into account as no incentives should be included, which can violate the fiduciary duties towards investors. For example, a scheme where a director gets paid in basis points of assets under management may lead to the director supporting acquiring assets. Would this director later advise disappointed investors to redeem? There may be no end to scenarios of where and how these conflicts may arise, especially when situations of market downturns or operational breakdowns occur, but also when relationships get troubled. What is especially critical is when these kinds of conflicts emerge after board appointments, so well into directors’ tenures. Then looking back, especially after a crisis, it always looks obvious that in certain situations conflicts arise, and it is of course of important to not have the seeds of those conflicts embedded in the first place and to have an enforceable code of conduct regulating these conflicts. An assessment of independence of directors would also need to include any other meaningful associations, current or from the recent past, of themselves or of family members and/or a declaration no such ties existed or exist.
Independence also means the independence of the director on any individual mandate. Many professional fund directors typically build a portfolio of directorships and depending on the composition of this portfolio, a directorship can cause a financial or reputational dependency for the director, potentially conflicting with the effective exercise of the fiduciary duty; this of course needs to be avoided. A non-executive director who assumes the role of a director on the fund board as part of her or his position in, for example, the investment manager is to be welcomed as this director would have the benefit of smooth communications, a good understanding of operating conditions at the investment manager and the availability of resources to that executive. However, the board work may fall primarily on the independent directors when the dependent directors may become conflicted, for example when caught between interests of the investment manager and those of investors. This may eat into the collective responsibility, action, and effectiveness of the board as a whole. Also, there may be matters from which the dependent director needs to recuse herself.
Capital markets and operating models are characterised by massive uncertainty as new risks emerge
While September 2008 may seem a long time ago, many commentators are wary of signals, and many investors suspicious. Indeed, capital markets have become less traditional in their behaviour as taught for decades in business schools – traditional correlations between and within asset classes are being questioned. There is regular reporting on problems regarding pension plans’ funding gaps, especially as many have built up liabilities in the defined-benefit era, which require ongoing funding and risk taking. National debt crises remain unsolved, as debt levels keep on increasing, and it is uncertain how these crises will be resolved and what risks we will face along the way. The fear for (uncompensated) illiquidity is never far away, especially as innovative product structuring is not always completely understood by investors. Interestingly, while alternative investments have always been seen as in need of specialist attention, traditional investment products may now face non-traditional and idiosyncratic risks, which in essence require a similar level of vigilance in terms of oversight as is the case for alternative investments.
Besides capital market uncertainties, also, operating models of investment organisations have become more varied. Outsourcing of back, middle and front office functions has been done to various degrees, and the trend to catch-up and move away from the omnipresent spreadsheet and move forward with investments in technology to fulfil reporting requirements, to keep records, and to deal with new technological possibilities such as blockchain, digitalisation, predictive analytics, real-time client interfacing and the alike is irreversible. Besides these complexities, investment constructs also face the complexity of having to work across jurisdictions where the fund vehicle may be subject to one legal regime, the investment manager to another, the service providers, the investors and the investments potentially to other jurisdictions again – this causes potentially enormous legal uncertainty. While arbitration clauses in legal documentation, though sparse still, may be of help, this complexity is exacerbated by international competition between old and new jurisdictions, for example through the introduction of new legal vehicles. So, especially in this light, it is the outsourcing and delegation arrangements which harbour operational and legal risk, and which will attract increased regulatory scrutiny going forward.
In the meantime, the term risk has received a completely new meaning: the classical notions of risk such as counterparty (credit), market and operational risk are now being met with newer risk categories, such as conduct, cyber, fraud, misselling, model, regulatory risks and others. It is striking that, while quantitative risk models are being developed further and rightfully so, many risk categories cannot be captured in a quantitative model, let alone receive useful signals for effective risk management. Many quantitative risk models assume normal distributions, but fat tail events seem to occur more often than expected. Are quantitative risk models getting more accurate? Also, risk, with potentially different effects on different stakeholders, seems to change over the lifecycle of a fund and seems to exist in all corners of the investment construct, including with the service providers. It seems that change control and human judgement remain of key importance.
Investment governance is about supporting prospering investments, and boards can and should encourage this
What does this all mean for fund boards besides the mentioned independence? It means, at the least, that the fund board need to be equipped for the challenges the fund vehicles are facing going forward. Do the board directors collectively have the 1) time, 2) executive experience, 3) managerial and investment skills, 4) methodological, legal, risk and other relevant and recently certified knowledge and 5) proven integrity, to effectively discharge their responsibilities? In many instances the quick answer is yes, but on second thought an assessment of these five requirements may be warranted to evidence these ingredients for an objective, transparent, systemised and trackable fit-and-proper-test. Regulators have started to look into these requirements, but may become more explicit as they face public and political pressure. Indeed, given increased complexities and requirements it is difficult to see how a high number of intrinsically demanding board mandates can actually be performed in a credible manner by any one director, a service model that was popular in the recent past and remains allowed in some jurisdictions. However, while demands on directors will increase, investment managers need to take into account that noblesse oblige and they too will face increased demands.
Having a proper board supports the robustness and resilience, and hence the credibility of the investment construct, which in turn can help inflow of assets. Very large independent and bank-owned asset managers benefit from brand recognition and balance sheet, however mid-size and smaller asset managers will need to show performance on all dimensions, including their investment governance: due diligence professionals may pay increasing attention to this aspect. Lip service by asset managers to governance is recognised as such and does not receive too much credit – indeed, ticking-the-box-exercises, while cheap, typically do not provide too much protection nor real savings for investors and investment managers, which receive the lion’s share of fees and which may face the highest share of litigation and reputational damage when things go wrong, which is all the more painful if risks could have easily been avoided, minimised or mitigated by proper governance. In any case, it becomes clear that the economics of operating a fund will see changes. Management fees flowing to the investment manager will rightfully still make up the vast majority of the total expense ratio, relevant to the investor, going forward. However, the cost of governance will increasingly reflect the changing reality, increasing their minuscule share in the total expense ratio, as competition for the directors, which add the most value, heats up. At the same time, the attention on the total expense ratio will remain unabated.
Overseeing the fiduciary services providers and in the light of industry developments, including Weavering- and similar scares, what is clear is the need for an enhanced positive answer to the fit-and-proper-test, including a stronger representation of risk and investment-strategic skills on fund boards. Indeed, with the heightened scrutiny of the fiduciary and non-fiduciary responsibilities of fund boards, as shown in recent cases, for which a regular D&O-insurance coverage may prove insufficient, risk oversight may be the most important governance function of the board! Boards need to provide for the serving leadership in this, supporting the success of the fund on behalf of the investors, while watching out for the ethical lapses such as mentioned conflicts of interest or duties – all in all,not a job for the faint-at-heart…
Eelco Fiole, PhD, CFA, CDir is co-founder and managing partner of Alpha Governance Partners, a pure play fiduciary services partnership with presence in Copenhagen, Geneva, London, Singapore and Zurich and lectures a.o. Risk Management with the Swiss Finance Institute in Zurich. Previously he was a.o. COO Alternative Investments Switzerland with Credit Suisse Asset Management, which included approx. USD 17 billion in global alternative strategies. He is the editor of ‘Governing Complex Investments’, 2018 (forthcoming).