My focus today is going to be on funds, but clearly governance applies to all corporate entities or any other type of entity. Good governance practice is something that is evolving and is important for everyone, specifically in our industry, to be conscious of and aware of. So my presentation is going to talk about what governance is, the role of the directors and the board. I also feel it is important to touch on fund structure, which I will do. The composition and selection of directors I will touch on, and then a key point is the effectiveness of the board and how the board operates. This piece is focused also on predominantly the offshore environments of the Caribbean, Cayman, BVI and then the European jurisdictions of Luxembourg, Ireland and Malta.
What is governance?
Governance is a word that is used quite frequently today. Corporate governance really is the framework in which the senior body of a company or a structure operate and agree to operate. It has evolved over time, specifically over the last 25 years due to some of the large corporate scandals that have occurred in the US, the UK and other jurisdictions. The framework is now written down in terms of the corporate governance code, which is a voluntary code and applies predominantly to the larger organizations, listed companies globally.
It has been adopted in other jurisdictions like South Africa, Australia and to a lesser extent in places like the US and Norway. But it is a voluntary code and there is the requirement to either comply or explain if you do not comply. Many companies in the funds industry are not large global companies, but there is continuing pressure from regulators and from investors to be mindful of what the code requires, and to try and comply with that.
However, people do also refer to the area of fund governance, specifically. Fund governance needs to be considered in its own right because funds are different types of structures to companies. They don’t employ people: they outsource all of their activities to third parties, and therefore have different requirements. I will touch on those more specifically, but again it is a different business model that we all need to consider.
The role of the director and the board originally arose from company law, and still exists within company law, and that sets out what the role and responsibilities of the directors of a company are. It doesn’t add a lot of meat to the bone, and hence the arising of the corporate governance code and other similar documents that give interested parties a wider brief and understanding of what is required of directors. Clearly directors are there to look after and act in the best interests of a company, safeguard the company’s assets and to treat investors fairly.
The company’s articles also tie back to the company law in the relevant jurisdictions, setting out again the rules and requirements of directors and set out how the company at a high level should operate.
One of the things that has happened over the last few years, and in our industry specifically resulting out of the Weavering case, is regulators taking a closer look at the activities of directors and how they perform. That’s an area that we’re going to see continued scrutiny on in the future.
Over the last couple of years closer integration and communication has become the norm between the directors and investors, with directors being asked to make themselves available to meet with investors. I think that’s certainly a good move within the industry.
It is important that investors do have an understanding of who the directors are, what their skill sets are, and that directors make themselves available to meet with those investors. In relation to the actual role itself, it is a collective board making unitary decisions, which I think is important. It’s an ongoing debate in terms of some of the decisions that the board have to make, but it is a collective decision.
Normally on corporate boards you have got a combination of executive and non-executive directors, but company law does not define the difference between them, believe it or not. It looks upon directors in the same light irrespective of whether they are executive or non-executive. But clearly in relation to funds all of the directors are non-executive. So with the evolution of best practice, we’re seeing more demands on directors, more requirements, more time being spent on fund activities.
As I mentioned earlier, fund structures are different to normal corporates, and so we need to consider the different types of fund structure and how they are actually run at a board of directors’ level. We’re all very clear and understand that a fund is set up, invariably by an investment manager who has a particular strategy, who believes that they are going outperform the market, and investors want access to that manger, through a pooled vehicle normally. I touched on the fact that it is an outsourced model, and that all of the activities are outsourced to third parties: the investment manager, the administrator, the prime broker and the custodian, depository. The responsibility is on the directors to ensure that those parties are performing their duties and are compliant with regulatory requirements.
What we have seen is that this is now taking more demands and time from directors in relation to that oversight of delegates. In fact, in certain jurisdictions, the local regulator is requiring that the directors do that. So directors will be in touch with the investment manager more frequently, they will be doing annual due diligence visits, together with visiting the service providers to ensure that those parties are performing in line with their underlying agreements and in the best interests of the fund.
In relation to the fund structures, clearly after the last seven or eight years and what has happened in the marketplace, the focus is on risk management. Directors have become much more aware of that. Maybe the Weavering case added to that point. But the focus on risk management, understanding the strategy, ensuring that the monitoring and ongoing compliance is complete and up to date is definitely crucial for the board to monitor and continue to assess.
In relation to the board composition, in the UK HMRC are looking at the matter of UK residents being directors on offshore funds. No doubt that discussion will go on and continue but many of the managers that I know and work with, there’s still the belief that the majority of directors should be resident outside of the UK. In Ireland, you’ve still got the rule that there’s a requirement to have two resident directors, although that is now under review by the Central Bank. We’ll see how that evolves.
But in relation to the board, there’s now a requirement or a view that the board should be a diversified board. That’s to do with skill set and expertise, and to look at that composition on an ongoing basis to provide the necessary skill sets that the board need to have in relation to the underlying strategy and oversight of the funds activities. Clearly many boards have a representative of the investment manager as a director on the board, and I think most directors like that concept; it provides comfort and provides easy access to the investment manager for ongoing discussions.
Not only should the manager in looking at the directors and who should be appointed to the board consider the skill sets, but there are other areas I have set out here that they should also consider. Directors need to be continually available and engaged at a board level. Prior to 2008 we would all be aware of situations where board meetings were not held, directors didn’t turn up. Those days have gone, and I think the Weavering case brought that home to a lot of people and that engagement is only going to continue to increase over time.
One of the things that’s interesting is that the corporate governance code does set out some of these characteristics that the board should have, and a lot of the regulators are now giving that consideration to who should be on the board and the skill sets of those that are on the board. Things like: “the board should be cohesive but challenging”. Again that’s an interesting point, because that leads to overcoming things like group-think, where the board just act in sort of a passive way, without engaging and challenging the manager or any of the other service providers. So what we’ve seen is a lot more of that engagement, challenging and asking tough questions of the investment manager or the service providers on particular matters that are important to the board.
Independence of directors
The whole issue of independence continues has come up a lot. Independence is defined now as independent from any party to the fund, so independent of the investment manager, and of the service providers. This is something that’s got to be monitored on an ongoing basis. I have seen situations where each of the directors will confirm that they had or did not have conflicts at the start of each board meeting, which I think is a very interesting and good practice to do, because as you know, things change, and can change quite quickly, and it’s important to put on the table if there are any conflicts and then how they’re going to be dealt with. Normally the way conflicts are dealt with is full disclosure, and if there’s a matter to be voted upon, that individual would not partake in the vote.
Capacity is another hot topic in the market at the moment. It is being focused on by the regulators in relation to ensuring the directors have sufficient time to devote to the affairs of the company. Historically non-executive directors might have met twice a year, four times a year, and may not necessarily have reviewed information in the intervening period, but that is all now changing.
In places like Ireland and Luxembourg, the central banks are asking directors to stipulate the number of days they expect to spend working on funds. Instances have arisen where the regulator has come back and said “We don’t accept that number of days. It needs to be X,” and have insisted on an increased in the number of days allocated. That gives us a signal as to where the regulators are going, the time commitment that they expect is required by the directors to fulfil their duties.
In relation to the appointment process, that has also evolved over the last couple of years. This year in June there was a requirement in Cayman that directors be registered, and so there is now a registration process which includes submitting a questionnaire, CV, references and so on and so forth, and the payment of an annual fee. That needs to be done on an annual basis.
Within Europe, Ireland, Luxembourg and Malta is a similar process, but via a pre-approval process. There is a questionnaire, your references, your historical directorships, the amount of time that you spend on each of them, which needs to be reviewed on an annual basis.
So the whole process is becoming much more detailed, much more time-consuming with a lot more transparency around the director and the role that they are completing. In relation to selecting directors, I have seen instances where managers have asked for independent references, bank references, asked for due diligence questionnaires, and on occasions have asked for potential directors to talk to some of the investors. I can see this trend continuing more and more into the future.
I have talked about the regulatory process, and regulators specifically in Europe becoming more focussed on the role of the director, how the directors are working together, and the amount of time that the board spends on the activities of the company. In relation to effectiveness, they are now taking a closer look, and are stipulating in different documents how those activities should be carried out.
I suppose it’s important that the role of a chairperson be identified, and a strong individual appointed in relation to running board meetings, ensuring that the board individually and collectively has a voice in relation to discussion of matters, but also being available to carry out and follow up on action points that arise, both at board meetings and between board meetings.
I will make reference to a strong individual − strong as in a strong character, not necessarily strong in relation to influential. A strong person from an influential basis on the board does not necessarily work well, because the decision-making then may not necessarily be collective. Boards tend to work that out. Some funds have revolving chairmen, again it is down to the preference of the board with input from the manager, and the practice that they have carried out in the past with other funds.
Providing timely information
Management information is also crucial. We will all be aware of the quarterly board packs that come inches thick, the week before the board meeting. That process is beginning to change to a certain extent with more frequent information. Many managers produce a monthly update on performance and an analysis of the portfolio which I think most directors find very useful. Many managers are making themselves available to meet with the board or individual directors or speak to them by phone on a monthly basis, which I think the director community feel very happy and comfortable with. It keeps them involved, it provides them with more timely information.
In relation to management information the key areas revolve around performance, risk management, compliance and shareholder activity. Clearly they are the key areas that are important to managers and to investors. I have no doubt with changing regulation over time, this might change and increase. I have touched on the interaction between meetings. I think that’s important, and that view is shared by many of the directors that I talk to also. I think it’s important for the manager and the investor to know and understand that the director is available or the board is available at any stage for ad hoc board meetings, and also to keep the directors informed about the activities of the fund, how it is performing and the risks and challenges that they face, because clearly the more information you have, collectively as a board, the better the decision making process will be.
As funds get larger and more complex, the issues that arise are going to become more frequent. Interestingly enough, in the last six to nine months, certainly in Ireland, the regulator has introduced the concept of annual performance evaluation of the board, which comes directly from the corporate governance code. That’s probably not a bad thing. In effect, if you look upon directors not as employees, but nevertheless employed to carry out a certain function, well shouldn’t they then also go through an appraisal process of some sort?
It is not necessarily the same process as you might find in a corporate, but they should be carrying out some sort of self-evaluation. And that can be done through the board themselves, driven by the chairman, or we have seen instances where third-party consultants have been retained to work with the board to provide an annual performance evaluation. We will see more and more funds globally adopt that approach going forward. I also think the output of the evaluation will probably end up being disclosed in the financial statements, and I think it’s something that investors in the funds will look for in the future.
Conflicts of interest
I talked earlier about conflicts of interest. When you consider that many directors hold numerous appointments either with managers, independent directors on the board, other funds and service providers, there is the potential for conflicts to arise.
Conflicts can arise in many different ways, but the onus is on the individual director to ensure full disclosure to the board of potential conflicts. That’s an ongoing matter that needs to be considered by the board, because you do not want a breach of the director’s independence if at all possible.
Another evolution in corporate governance and fund governance is the appointment of sub-committees over the last couple of years. The sub-committees have tended to focus on two areas: one is audit and the second is risk. Today, this predominantly applies to and is undertaken by larger funds and larger fund management houses, where rather than tie up the full board for monthly meetings, these committees would meet on a regular basis, occasionally with the investment manager and some of the service providers and then report back to the board. That is probably not a bad idea.
I have seen that happen in several instances, and I expect as funds get bigger and the demands on directors grow, that those activities will be delegated to a sub-committee. Clearly you can’t delegate the responsibility, so the ultimate responsibility rests with the board in terms of the decision-making and the action they take.
I touched on it earlier, and that is external communication, and the directors making themselves available for meetings with not only service providers, but more importantly with investors and other third parties. I think we have seen an increase in this activity.
Keeping up to speed
In relation to other considerations that investment managers, investors and directors who sit on boards need to consider, these are some other topics that I feel it is important to highlight. We are in a world in which regulation is only going to change and continue to increase. In the short term we have AIFMD II, we have the changes in UCITS coming down the road, and a multitude of others. And the challenge for directors is to continue to keep up to date with this change.
That process has been picked up by some regulators, where they are requiring directors on an annual basis to basically self-certify that they are still fit and proper for the job. Now how directors do that clearly is down to themselves, but directors attending training programmes makes a lot of sense. It provides information in relation to what is happening in the marketplace, the changing environment and I think it’s going to be important and expected, specifically by investors, that directors do keep abreast of what is happening.
The market practice will continue to change. The demands on directors will continue to grow. If you consider the requirements of directors today and compare that to 2007, it’s dramatically changed – no two ways about that. And I suspect that if we roll five years forward from now, it will continue to have evolved from where it is today, albeit the overall responsibilities may not have changed. And everybody needs to understand that.
The relationship with auditors will continue to be important. Clearly that is a key thing that directors must continue to focus on, ensuring that there is a good working relationship. The larger funds tend to have audit committees, which will help with that process. But it is crucial, because on occasions some funds do have issues, and they need to be resolved fairly quickly, as the regulatory filing deadlines around the world are quite tight. In certain jurisdictions you have to file your audited financial statements within four months. It does take some additional time and requirements both of the board and the investment manager and service providers to ensure that the auditors have all the information they require and that any audit findings are resolved as quickly as possible.
On remuneration, it is driven by each of the jurisdictions, and in each of those jurisdictions, there is a range of fees, depending on the structure of the fund, whether it’s a master feeder, whether it’s standalone, and the complexity of the investment strategy. Managers and directors need to be aware of what the range is. Over time, I suspect that the fees will increase because of the demands being placed on directors, but again, if you’re looking to set up funds, just be conscious that the range differs in each of the jurisdictions.
One of the things that the corporate governance code does lay out is that the directors as a body or individually should have the right to legal advice if they need that, and that’s not something that people often consider. Clearly in the fund’s structure the fund will have appointed a law firm that will help them in relation to updating their documents on an ongoing basis, together with any other issues that need to be dealt with. But it is something that boards do now consider. At least there’s the availability of seeking legal advice if the board feel it is necessary in terms of their own activities.
The final point is considering insurance. Most funds I have had experience with tend to put insurance in place. In the event that something might happen, at least it will allow the fund to use that insurance policy, if for nothing else than to assist with the payment of legal fees in defending the company and the board should anything unfortunate occur.
I have covered a large area, but the focus and the message is that this is an evolutionary space. Corporate governance is continually evolving, and it is being driven by a combination of things. One is regulation, and changing regulation, and also the increased demands of investors. We the director community need to be aware of that, and need to position ourselves so that we can provide the best possible service and support to the companies and funds for which we act.
The Evolution of Governance
The changing roles of non-executive directors
RAYMOND O’NEILL, A.R.C. DIRECTORS LTD
Originally published in the November | December 2014 issue