Article by Christopher Day, Carne Global Financial Services Limited

Background

The vast majority of offshore hedge funds are registered in the Cayman Islands. In recent years the hedge fund industry has seen a continuous shift from high net worth individual investors to institutional investors, and these types of investors are set to increase their allocations to this sector of the investment management industry. It is a change that has brought forth a more demanding agenda for fund governance and oversight, catalysed by the recent controversial industry misconduct rulings such as Weavering, and there has been much revelation of poor and inadequate fund governance drawing public attention to the subject of board governance. Cayman Island ‘jumbo directors’, ‘Walmart model’ and ‘high volume, low touch’ governance approaches have forced the industry stakeholders to rethink fund governance ‘legacy’ practises.

At the centre of the fund governance structure, the fund’s board plays a pivotal role in ensuring and reinforcing the smooth operation of the fund, as well as fulfilling statutory, regulatory, legal and fiduciary obligations. Ultimately, the board has the responsibility for safe guarding investors’ capital and overseeing the management of the fund. In order to achieve these goals, a fund’s board must initially have a balanced composition which possesses appropriate specialist expertise, knowledge and experience. However, during the life cycle of a fund, the composition of the board is likely to experience restructuring and changes.

Drivers for Changes and Considerations

Any proposed changes to a fund board’s directors should be considered only if it is in the best interest of the fund and its shareholder. When considering restructuring or changing the fund’s directors, it should be noted that the focus needs to be on the overall objectives instead of on the position each stakeholder holds. In other words, the motivation for changing directorships should be derived from the needs of fund governance, and equally important, by the evolution of the fund board to a best practice model. By the same token, it should also be borne in mind that when communicating with the public and key relationships, the message articulated by the board should always demonstrate best practices, and regulatory pre-emption, proactive governance and management style.

The reasons for changing or restructuring the board can be various; from natural retirement or voluntary resignation, to circumstantial events – when a more demanding agenda lies ahead with sensitive issues to be considered, for example.

The former situation, where a vacancy on a board is created owing to retirement or resignation, would typically follow the rules in the fund’s constitutive documents. Requirements include notification of the change to the fund’s Registered Office and filing with the Registrar of Companies. An updated offering document with the new director biography included might be prepared and will then be filed with the Cayman Islands Monetary Authority (CIMA). The updated offering document would typically be sent to investors. On a practical level, there may be authorised signatory lists at brokers or the administrator to update.

The latter circumstances can be motivated by an initiative to strengthen fund governance and acquiring more appropriate personnel to demonstrate best industry practices and boost the board’s capability to actively engage in good governance practices. This will benefit the fund as investors have widely reviewed their opinions on the corporate governance model in the post-Madoff era. As a result, many funds have implemented a reform of their boards where the previous board might be comprised solely of representatives from the investment manager or directors who are related/connected to the investment manager. When this situation arises, reference should be made to the procedures found in the fund documents. These typically include director resolutions or shareholder resolution, i.e. either a new director can be appointed by passing a resolution by the existing directors, or by the voting shareholders.

The evolution of global capital markets provides fertile ground for new products and strategy development within hedge funds. The likes of CTA/managed futures and macro strategies have seen sizable capital inflow and have gained popularity among institutional investors in recent years. This development also demands that the boards are equipped with directors who have the relevant capabilities to govern sophisticated investment strategies and trading techniques. Those funds that are engaged in innovative strategies should endeavour to appoint directors who are best fitted to practice their roles at a reasonable capacity.

Dissatisfied investors can also apply themselves to changing the board, especially if they are unhappy with the fund governance or performance of the directors; or they could be dismayed by certain member(s) of the board treating investors unfairly, acting against shareholder interests, etc. Prompted by other stakeholders, specific directors could be, in rare circumstances, urged to resign or asked to be removed from the board.

Conclusion

It is widely recognised that there should be at least one credible independent director on a board. Owing to the neutral position an independent director holds, he/she adds a layer of protection that effectively analyses, documents and acts on behalf of investors’ interests. One fund domicile has implemented a code of conduct where it is a requirement to have an independent director on the board of a fund.

As a best practice going forward the industry will adopt good quality independent fund governance. With careful consideration and planning, changes to boards enhancing governance standards can be implemented and communicated to interested parties with a positive and proactive message.

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