Should Hedge Fund Directorships Be Limited?

Disclose and sever affiliations

Originally published in the February 2010 issue

Two issues continue to generate debate among offshore legal practitioners and independent fund directors. The purpose of this article is to review some of the factors at stake and offer some tentative conclusions. One debate has focused on the rules governing whether hedge fund directorships should be limited, while the other is concerned with whether offshore law firms should severe their relationship with affiliates.

Disclosing directorships
The Securities and Exchange Commission recently adopted amendments to certain proxy rules to require disclosure of any directorships at public companies and registered investment companies held by each director and nominee during the past five years (even if the director or nominee no longer serves on that board), together with the names of the companies in which the directorships were held. While this amendment should not affect offshore funds or their directors (on the basis that offshore funds do not appear to be required to be registered with the SEC and therefore do not appear to be currently subject to the new SEC rules), the concept should be of interest to both regulators and directors of offshore funds.

Should the regulators in offshore jurisdictions follow the lead of the SEC and apply a similar rule to all offshore funds, such a disclosure may be a frightening task for those offshore directors that sit on the boards of 600 to 1,000 companies (which may either be registered or not registered with a regulatory authority responsible for investment funds). On the other hand, it would provide investors with a higher level of transparency regarding the number of directorships held by any single director and may affect an investor’s perception as to whether or not that number might affect a proposed director’s performance on a board of an investment fund and that director’s ability to discharge his duties to that fund.

Industry discussions in the Cayman Islands suggest that there is no real way of deciphering what number of directorships is appropriate to be held by any single director. Each company has unique characteristics and may require a different level of attention (depending, for example, on the frequency of board meetings or NAV reviews). In addition, the level of infrastructure may also determine whether a given number of directorships can be managed efficiently. The appropriate number of directorships, therefore, will vary on a director-by-director and a company-by-company basis.

Notwithstanding the difficulties, investor due diligence on any company should seek to determine the number of directorships held by a proposed director. In the absence of placing this question on a due diligence questionnaire and failing the implementation of a policy by a regulatory authority to require such a disclosure, the number of directorships held by any single director of a Cayman company is impossible to decipher. Understandably, some directors may not want to provide this disclosure; however, in an environment where risk and transparency are key considerations, it will certainly help investors to make better informed decisions. The registrar of companies in the Cayman Islands is probably the best party to make a transparency tool available to all prospective company stakeholders in order to assist them in making overall assessments. This is because Cayman companies’ law requires that any change in the directors of a company be filed with the registrar of companies within 30 days of such change. Given timely filings, the Cayman registrar of companies should always have an updated directors’ register whether or not registered as a mutual fund or otherwise with the Cayman Islands Monetary Authority. It probably makes little sense to trouble CIMA to make this disclosure because not all Cayman companies are required to register with CIMA; only those companies that voluntarily register with CIMA or that fall within the ambit of the applicable regulatory laws will show up on any list produced by CIMA. As the leading offshore domicile for hedge funds, the Cayman Islands should set an example for other offshore jurisdictions to follow. Regardless of the infrastructure in place at any firm of professional directorship service providers, it is doubtful that any director can properly discharge his duties to any company when the director sits on the board of 600 other companies, some of which may be investment funds with high risks and complex strategies.

Severing affiliate relationships
The introduction of various independence rules has led to the restructuring of public accounting firms. Their evolution into multi-disciplinary business service consultancies represented a challenge to the ability of auditors to maintain a credible independence. Should this principle be applied to law firms, in particular, those located in offshore jurisdictions? In the Cayman Islands it is customary to see a law firm provide initial and ongoing legal advice to a fund structure, while the same law firm or its partners own 100% of the shares of another company which supplies “independent” directors to the same fund structure. With this arrangement, prospective clients are provided with a convenient, one-stop shop. Regarding directorships, clients avoid the hassle of searching the entire offshore jurisdiction for a slate of directors. The law firm simply offers up its 100% owned entity as a directorship services provider. This also benefits the offshore law firm as its partners can dip into the revenue of the affiliate providing the directorship services.

So far, all parties seem happy with the engagement. Investors and managers should, however, ask whether they may face any risks or potentially compromising issues arising from the law firm/subsidiary relationship. To illustrate, imagine the following scenario:

• there is a fund scandal
• directors of the fund are suspected of fraud
• offshore law firm is a long-standing legal advisor to the fund
• offshore law firm’s subsidiary or affiliate employs the directors of the fund

One logical option would seem to be for the fund to take action against its directors. However, the law firm is conflicted; it has all that money in one hand and all that money in the other hand. The likely outcome: no court decision and a settlement out of court. Had the law firm’s affiliate been an independent third party, it might have, on behalf of the fund, taken court action against the fund’s directors. It could mean substantial damages being awarded to the fund and criminal convictions for the directors. From this, one can imagine a myriad of other possible conflicts and disadvantages that may confront an offshore fund and its investors. At an earlystage, therefore, investors and managers should consider whether the offshore law firm-subsidiary/affiliate relationship is appropriate.

An objective view is that the relationship is not appropriate because of the serious nature of the conflict of interest (which should not be waived away by a conflict waiver letter). Offshore law firms should not offer up their affiliates as directorship service providers for a fund in cases where the law firm acts as legal counsel to the fund. If the firms won’t do this, regulators in the relevant offshore jurisdictions should consider implementing independence policies for law firms to operate in a similar manner to the independence rules that apply to public accounting firms. Such rules should severe the ties between offshore law firms and their affiliates, giving rise to independent entities. The shareholders of these entities should also be independent of the partners of the former affiliated law firm. For fund investors and managers, this means greater transparency and better risk assessment in the process of offshore fund formation and allocating assets to offshore funds.

Alric Lindsay is a non-executive director to Cayman Islands based investment vehicles and an attorney at large. He is a former attorney with Maples and Calder and Ogier and has worked as a senior compliance analyst with the Cayman Islands Monetary Authority.