The Independent Director

The Independent Director

Simon Palmer, Maples and Calder
Originally published in the October 2004 issue

The term “independent director” whilst not a term of art when used with reference to any company, and no more so a hedge fund, denotes a director who is independent of the company’s management. But in the case of a hedge fund, the term generally refers to the director’s independence from the company’s promoter or investment manager rather than from its executive management. However, as with any company, if one scratches beneath the surface of this simple definition, one finds the more complex issues that require resolution.

Independent directors of hedge funds are drawn from a variety of sources and for a variety of reasons. It is usually the promoter of a fund (which almost invariably thereafter either owns the investment manager or is connected with it) who arranges or approves the appointment of the fund’s initial directors. Consequently, an independent director is often acquainted with the principals of the investment manager on a personal or business level. He may also serve as a director for a number of other funds promoted by the same manager (and so derive substantial income from his relationship with the manager). In some other cases, the director is an employee of the fund’s administrator or of a firm to which the administrator refers directorship business.

In the past, in relation to the UK promoted funds the primary consideration in appointing an independent director for its hedge fund was to maintain the offshore tax status of the fund or to assist in the tax planning of the investment manager. The calibre and experience of the director was often not of great concern. The annual cost usually was. However, recent hedge fund litigation and mutual fund scandals and, in the wider business community, the Enron and Parmalat frauds have resulted in increased onshore tax and regulatory scrutiny of offshore hedge funds with the result that all parties involved with hedge funds are now focusing on the issue of corporate governance. Promoters, investors and regulators now increasingly expect a higher level of sophistication and expertise from the independent director of a hedge fund. Independent directors too in the light of the additional scrutiny consider more carefully the potential liabilities which may result if they do not properly discharge their duties.

So what is the role of an independent director of a hedge fund? In one sense, the term “independent director” is something of a tautology in that all directors, in managing the affairs of their company, are supposed to act independently of any other interests they may have and of each other. The law makes no distinction between a director who is appointed at the suggestion of the investment manager and one who has no affiliation whatsoever – their fiduciary duties to the hedge fund are the same.

In broad terms, a director has a duty to act honestly and in good faith in the best interests of the fund. In making decisions, he is required to consider only the interests of the fund and not those of any other interested party. These tests are largely to an objective standard.

A director also has a duty to act with the care, diligence and skill which would be displayed by a reasonable man with his knowledge and experience in the circumstances. These tests are partly subjective. Although he is not required to exhibit a greater degree of skill than may reasonably be expected from a person of his knowledge and experience, where a director has expertise relevant to a company’s business (as is usually the case with directors of hedge funds), a court is likely to expect a higher standard of skill and diligence than it would from a director not in possession of such expertise.

A director has a duty (arising from his position as a fiduciary) not to put himself in a position where he has a conflict of interest between the business of the fund and his other business interests. On occasions, however, the interests of the fund and its investment manager or administrator will not align and this can place a director (even one who is nominally independent) in a position where he has a conflict of interests. This situation can arise not just on the initial establishment of the fund when the contracts with the investment manager and administrator are being negotiated but also in the ongoing operation of the fund, over performance issues such as the valuation of assets, changes to investment strategies and restrictions as well as, of course, in the monitoring of the performance of the investment manager and administrator.

The common law position on directors who are interested in contracts with the company is strict. Without more, such a contract is voidable at the option of the company and the director is liable to account for any profits made unless the contract is approved or ratified by a general meeting of the shareholders or otherwise permitted by the constitutional documents. In practice, this position is invariably established to some degree by a fund’s articles of association or by-laws and, in some jurisdictions, by statute. Typically a director is permitted to both discuss and vote on a matter in which he is interested, as long as he discloses his interest to the fund (in the form of the board of directors) beforehand. Provided his interest has been properly disclosed, a director is not liable to account to the company for any profits received. Usually the articles also permit a director to give a general notice of his interest in a particular company or firm which then obviates the need to disclose the interest each time it becomes relevant to a matter being discussed. Disclosing a potential conflict of interests, however, does not allow a director to vote against the interests of the fund. He is still required to consider only what is in the best interests of the fund in making a decision. In the case of a flagrant conflict, this may be difficult, in which case it would be appropriate for the director to excuse himself from the discussion altogether, notwithstanding that his interest is disclosed.

The conflict of interest that can arise for a director on the initial appointment of the investment manager or administrator is sometimes partly circumvented by including a provision in the fund’s articles or by-laws mandating that appointment. The ongoing position of the investment manager and administrator may also be entrenched to a degree in the fund’s constitutional documents by requiring a shareholder resolution to approve any proposal to terminate, or vary the terms of, their appointment. If a director has other interests which may conflict with the interests of the fund, it is important that these are properly disclosed to shareholders in its offering memorandum or prospectus.

Another common law duty which is relevant to the independent director is the duty of confidentiality. A director may sit on the boards of two funds with different investment managers but substantially the same investment strategies. In such a position, he has a duty to ensure that confidential information received or obtained in his capacity as a director of one fund, for example the investment positions of the fund or proprietary research of the investment manager, is not disclosed to the directors or investment manager of the other fund (unless such information is already in the public domain).

The law recognizes that the role of a director is intermittent in nature and generally performed at periodic board meetings (unless the director has additional responsibilities under a separate service agreement). Thus, a director is not required to give continuous attention to the affairs of a fund and he is not bound to attend all meetings, although he is expected to attend whenever he is reasonably able to do so in the circumstances.

The board of directors may delegate particular functions to an individual director or officer of the fund or, more usually, to a third party if this is permitted by the fund’s articles or by-laws. The ability to delegate to specialist service providers is obviously critical to hedge funds. As long as the directors have acted properly in delegating in the first place, then, in the absence of grounds for suspicion, they are justified in trusting that the service provider performs those duties honestly. However, the directors must diligently exercise their responsibility to monitor those service providers on an ongoing basis.

Importantly, a director owes his duties to the fund as a whole and not to any individual shareholder or service provider regardless of who appoints or may otherwise employ him. However a director can represent the interests of a particular shareholder at board level as long as he does not contract to vote in a particular way on a particular issue and, as his primary duty, he acts in the interests of the fund in all respects.

If a hedge fund has been properly set up and the appropriate authorizations and delegations have been put in place, then, as long as the fund is trading profitably and in accordance with its investment strategies and restrictions disclosed in its offering memorandum, the role of the directors in its ongoing operations generally will be limited to (1) periodically reviewing the business and performance of the fund and its service providers, and (2) dealing with issues which fall outside the operating parameters put in place.Such issues may include, for example, approving special arrangements with key investors relating to liquidity and fees or approving variations to investment strategies and restrictions requested by the investment manager.

In order to be properly equipped to deal with the issues which will confront him, an independent director needs to have an understanding of the fund’s investment strategies and the nature of the underlying asset class (its liquidity and volatility). In particular, directors should be aware of how frequently the fund trades, whether it trades on margin or uses other forms of leverage and whether it engages in short selling or uses derivatives (for hedging or otherwise). In addition, a director needs to be aware of the logistical issues facing the fund’s administrator in dealing with subscriptions and redemptions and calculating net asset value and also the laws and regulations affecting the fund.

As the scrutiny of hedge funds and their management structures by onshore tax authorities and regulators, both on and offshore, looks likely to increase in the future, it is in the interests of all parties involved with a fund for it to have an independent director on its board of the appropriate calibre and with the requisite skills and experience. Such a director will be able to act credibly and independently in making decisions for the fund and provides comfort to the fund’s investors and service providers. He will usually seek to ensure that the fund adheres to the proper principles of corporate governance. This will reduce the risk of mismanagement and consequent litigation and strengthens the integrity of the fund’s tax and corporate structuring.

Simon Palmer is a partner at Maples and Calder. He advises on all aspects of corporate and commercial law with particular emphasis on hedge funds and other investment funds.

Maples and Calder is the largest law firm in the Cayman Islands. It advises leading international law firms, major financial institutions, international corporations and high net worth clients on all aspects of Cayman Islands law. It also has offices in the British Virgin Islands and Jersey (advising on the laws in those jurisdictions), London and Hong Kong. Its subsidiary, Maples Finance Limited provides a full range of management and administration services to open and closed ended investment funds