It is important that a fund’s directors include individuals with no conflicts of interest, and there are pros and cons to selecting them from some of the more obvious sources of candidates. Philip Dickie and Greg Bennett explain.
Imagine that you are watching your team play in the finals. An incredibly close match is ruined in the final minutes by a dubious call from the officials, which costs your team the win. Now imagine that the officials had been appointed by the other team. No matter how impartial they may have been, or tried to be, you will always question whether their loyalties played any role in that call.
The fund industry is made up of many interested parties, both active and passive, often with competing interests. To follow our analogy, a fund’s directors are officiating the game—ensuring that it flows in accordance with the rulebook and making the tough (and sometimes unpopular) decisions that determine the outcome. With such responsibility, the question often arises as to who should perform this pivotal oversight role for a fund.
It is normal for all parties to want to protect their individual interests, but if their presence on the board of directors results in a real or perceived bias it may agitate other parties who feel that their interests are at risk of being prejudiced or disregarded. It is not necessarily the case that the parties in power will impinge on the rights of others, but perceptions can create the appearance of impropriety and could lead even the most rational person to believe otherwise.
A good example is the 2011 case of Weavering Macro Fixed Income Fund v Stefan Peterson and Hans Ekstrom in the Grand Court of the Cayman Islands. In this case, the fund’s directors were the brother and stepfather of the portfolio manager, and they had clearly been selected to protect the portfolio manager’s interests. Not all situations involve such blatant nepotism, but peeling back the layers will, in many cases, reveal other, less overt, conflicts of interest.
A fund typically has no employees, opting instead for a coordinated interaction of specialist service providers to carry out its business. As a corporate body, a fund can act only through its agents—primarily the directors. Under the laws of the favoured fund domiciles, a director’s fiduciary duties to a fund include those of loyalty, care, and good faith. These duties are owed to the fund as a whole, not to any individual shareholder, creditor, or service provider.
As Justice Jones rightly pointed out in his ruling on the Weavering case: “Directors owe fiduciary duties to their companies to act bona fide in what they consider to be the best interests of the company … and not to place themselves in a position where there is a conflict between their personal interests and their duty to the company.”
It is important, then, that the composition of a fund’s board is selected in such a way as to avoid possible conflicts of interest that could interfere with their loyalties to the fund. To the extent that it is possible, directors should be independent of all other stakeholders who are in a position to influence, or benefit from, the actions of a fund. A director with mixed loyalties represents, in the best case, a minor inconvenience to the board, but in extreme cases he or she can be a severe impediment to its effective operation. The director may have a moral hazard and be forced to choose between two conflicting forces. In such cases, if individuals are employed by a service provider, they may feel compelled to side with their employer, or defuse the situation by resigning from the board— neither of which is an acceptable outcome.
When selecting a board it is important to engage individuals with the necessary skill and experience, but it is equally important to consider where their loyalties lie and whether they are, in fact, independent of all interested parties. A board should always comprise a majority of directors who are truly independent.
Proponents of having a representative from the administrator point out that such an arrangement enhances the board’s access to information and knowledge of administrative processes. This argument can be effectively countered, however, as there is a good supply of independent directors with previous experience in fund administration who do not work for the current administrator, and are thus not conflicted. It is true that a representative from the administrator may bring fund-specific knowledge to the table, but in a properly structured governance model the administrator will be invited to participate in board meetings and share information with the board anyway, so it is not necessary for him or her to have a vote.
Some administrators will supply only members of their senior management team to serve as directors, believing that this mitigates the potential for conflict, as they are removed from the actual performance of administrative tasks. These individuals, however, do not have sufficient time to devote to board duties on more than a handful of funds, given their full-time responsibilities to their own firms, and at such a high level it should be presumed that they have an economic interest in the administration fees earned from the fund. Their lack of day-to-day involvement in the fund’s administration also means that they are unlikely to have the granular fund-specific knowledge that would be the primary reason for having an administrator representative on the board.
Mid-tier administrators (representing the majority of firms that still offer directors) are more likely to have an economic dependence on the fees derived from a large client or group of clients. Individuals with such dependence may not be willing to challenge the investment manager or other board members, or even express their true thoughts, for fear of retribution against their firm.
There may also come a time when the fund chooses to change its administrator. This leads to the question of whether a director should also resign from the board, if his or her firm is removed as a service provider. If so, the fund will not only have the transition of fund administration to deal with, but will also lose crucial board continuity at a time when the fund is going through important changes. The potential negative consequences of appointing an administrator representative far outweigh the potential benefits.
The primary purpose of a fund is to facilitate investor access to the talents of a particular investment manager. Thus, it is common practice to have a representative of the investment manager on a fund’s board, even though many of the concerns related to administrator representatives are also relevant here: the investment manager is the most significant and highest-paid service provider, so the potential for conflicts of interest is greatest in these situations. However, the information and transparency that can be provided by such individuals is considerable. Access to this knowledge is key to the effective governance of the fund, so it is often worth managing the inherent conflicts of interest to obtain this.
“It is not necessarily the case that the parties in power will impinge on the rights of others, but perceptions can create the appearance of impropriety.”
In recent discussions with large allocators we have found that many are in favour of having a representative from the investment manager on the board—partly because they bring transparency and understanding of the fund strategy, and partly because they feel that it enhances the manager’s accountability. A criticism also heard from these allocators is that investment management experience is lacking in the collective expertise of many boards. The presence of a manager representative partially, at least, mitigates these concerns.
One should view investment manager representatives, then, as a desirable, non-independent component of an effective fund board— provided that such individuals do not represent a majority of the board.
Representatives from legal counsel serving on a fund’s board may have a conflict of interest, especially if their firm has been selected by, and advises, the investment manager. A number of offshore law firms have created affiliated companies so that a separate team of individuals provides directorship services to their clients, but often the economic reality is the same—with the law firm’s equity partners directly benefiting from the appointment.
If the intent is to appoint an individual from one of these affiliated firms, the board must be clear on the individual’s level of involvement and loyalties. Specifically, will he conduct his own thorough review of documents or rely upon his colleagues on the other side of the Chinese wall? And will the appointee provide assurances that he will remain a director through troubled times, even if this is not convenient for his legal counterparts? If a firm is conflicted in a distressed situation and forced to choose only one revenue stream, legal fees are generally more lucrative than a director’s stipend.
A concept that has been increasingly discussed of late is the imposition of an individual on the board to represent the interests of a particular investor, much in the way an activist investor would appoint an individual to the board of listed entities that it invests in (to be clear, this is a different discussion from the investors’ collective rights to appoint or remove directors, as is typically provided for in a fund’s articles of association). This individual would be appointed to the board of several portfolio funds held by the investor, and is accountable to that firm.
While this may be attractive to an investor, it introduces additional considerations for the individual serving as the director. The laws of several jurisdictions, including the Cayman Islands, do not provide for the concept of proportional representation in corporate governance. Each director owes his fiduciary duties to the fund, being the collective whole, and cannot be seen to unduly favour any one investor. Investor-appointed directors may find themselves standing on both sides of a transaction, and must carefully balance their duties to both parties. Their loyalties may be further tested when actions of another investor are contrary to the interests of their benefactor. A question also arises as to whether such directors will resign when the investor redeems, a practice that could result in relatively high turnover of directors over the life of a fund.
We are very much in favour of institutional investors suggesting independent directors they are comfortable with when they perceive a fund’s governance to be lacking but, in our opinion, the only time it is appropriate to have one investor appoint a director is on the board of a single-investor fund.
A number of individuals serve as director to multiple fund structures, either as part of a professional services firm dedicated to providing these services, or on their own. These directors should be selected on the basis of individual merit and the support structure that surrounds them. Such individuals are typically independent, unless they are economically dependent on their fees derived from funds under the control of an investment manager, or they are affiliated with a firm that is providing legal, audit, or administration services to the same fund.
When selecting board members it is advisable for a majority to be professional directors. If there are any non-independent directors involved, their professional colleagues will know how to handle the inherent conflicts and ensure that the proper checks and balances are in place. This is a role that professional independent directors can, and should, play.
As the fund industry matures and becomes increasingly institutionalised, many investment managers and allocators have come to rely on fiduciary firms that reflect the same sophistication in their own practices to provide independent and experienced individuals to create an effective governance culture.
Your team may win or lose, but with prudent diligence and selection of the officials at least it will be a fair game.
Philip Dickie is a director at fiduciary service provider Harbour. He can be contacted at: firstname.lastname@example.org
Greg Bennett is a director at fiduciary service provider Harbour. He can be contacted at: email@example.com
Philip Dickie is a director of Harbour and serves as an independent director to funds. He has 18 years of international experience in the financial sector, having worked in managerial roles at Deloitte, The Bank of Bermuda, and UBP prior to joining Harbour. He is a CA, CPA and CAIA.
Greg Bennett is a director of Harbour and serves as an independent director to funds. He has more than 15 years’ experience, having held senior positions with PricewaterhouseCoopers, UBS, Butterfield Bank, Butterfield Fulcrum, and HedgeServ prior to joining Harbour. He is a CA, CPA and CFA.