These are truly interesting times for fund directors, and it seems like everyone is weighing in. Recent court rulings and press reports in the wake of the Bear Stearns hedge fund case, among others, brings the issue of director independence sharply into focus and raises serious questions about the efficacy and suitability of affiliated directors to offshore hedge funds, especially those managed within a hedge fund complex regulated by the United States SEC.
An independent director should mean that a board member is free of conflicting loyalties that would adversely affect his professional judgment and ability to discharge his fiduciary duties in an impartial, objective and unbiased manner; for example, the SEC staff has continually emphasized that fund directors have access to legal counsel that is “free from conflicting loyalties”. The best guidance on fund director independence promulgated by SEC fund governance rules that address the independence of fund directors can be found in “Role of Independent Directors of Investment Companies” (Release Nos. 33-7932; 34-43786; IC-24816).
Although offshore funds are not directly subject to SEC rules, many investment managers of offshore funds remain registered with the SEC, so dms Management Ltd. (dms) continues to recommend that, for the avoidance of any doubt, SEC registered investment advisers adopt the SEC fund governance rules, as applicable, for their offshore hedge funds as best practice.
Independence is fundamentally important and necessary because independent directors play a vital role in resolving conflicts of interest between a fund and its service providers; and also in approving principal and agency cross trades like those now under investigation in the Bear Stearns funds. These transactions attract a high degree of scrutiny from regulators and it is critical that true independence be evident and demonstrated.
There have been numerous instances in dms’ history, where investors would have suffered significant losses if we did not take appropriate action as independent directors, the most common circumstances being (i) improper treatment of expenses (ii) charging the cost of service provider errors to the fund and, of course, (iii) improper or fraudulent valuation of investments.
A challenging opportunity
As the first Head of Investment Services of the Cayman Islands Monetary Authority (CIMA) in 1998, I was responsible for establishing the Investment Services Division (ISD) and developing and implementing the key regulatory policies and strategies for the ISD. In 1998, Cayman was far from the dominant jurisdiction it is today and this was a challenging opportunity. I listened carefully to and worked closely with market participants to develop and implement regulatory principles, policies and procedures that were both effective and market friendly. Then and now, getting to YES on good ideas that maximized investor value was paramount.
It was also important to learn when to say NO. During my tenure, I brought the first enforcement cases against hedge funds in the Cayman Islands. In these cases, the service providers did excellent work detecting and reporting the abuses, but the directors did not act appropriately on the information. We have always had first-class talent in the legal, audit and administration professions, but in that era, inaction or abandonment from directors was frequent. Many didn’t reside in Cayman and could not be found, or lacked the ability or willingness to act to protect investor interests. For any fund control structure to work effectively, true collaboration needs to be achieved with all service providers and corporate governance was then the missing link. A clog in any artery will make the whole body sick so if those failures were allowed to fester, it would have undermined the credibility of the entire regulatory regime. To prosper, the Cayman Islands needed to have first-class corporate governance service providers to complement the other first-class professionals in the industry.
These enforcement initiatives took courage because the decision to prosecute is frequently unclear, often controversial, and involves significant judgment. However, I felt strongly that vigorous enforcement would send a clear signal to the marketplace that the Cayman Islands would not tolerate any form of investor abuse. The support I received and the lessons learned, made me more courageous and smarter about making hard decisions and how to lead in difficult situations. The mindset of a regulator and an independent director is the same – effective oversight. Independent directors are the referees in the game, we don’t interfere in the play, we don’t take sides, but we call the fouls according to the rules.
Independent directors should prove their worth in a crisis. Like a firefighter, independent directors should be running in when others are running out. Today, dms has actively lead the fight to protect and maximize the interests of investors and creditors in some of the most major, high-profile hedge fund blowups, winning the praise of renowned publications like the Wall Street Journal.
Independent directors are not involved in the day-to-day operations of the fund and it is not realistic that the single mind of any director can truly independently understand and monitor the full range of risks and complexities in today’s highly sophisticated hedge fund. They do not, nor should be expected to, interfere or dabble with the orderly operations of the other service providers. Some argue that they should. This argument is specious and ultra vires of director powers. Directors are ultimately responsible for the fund, but not the operations of the various service providers. Those operations are rightfully the responsibility of the governing body of the respective service provider. An independent director cannot succeed without the support of the service providers and – vice versa – mutual success depends on the effective interdependence of the various service providers.
Effective regulation
It is not coincidental that as the quality of corporate governance has increased, the number of enforcement cases brought by the CIMA today has been significantly reduced even as the industry has grown. Additionally, this is a testament to the increasing effectiveness of private sector regulation. Self or private sector regulation can be highly effective as evidenced by SROs such as FINRA and the NFA among others.
As the independent director profession develops, ideas are emerging to shape the future of the industry. One good idea was the development of a SRO to work in true collaboration with other industry constituencies. The newly-formed Cayman Islands Directors Association (CIDA), of which I am proud to serve as vice-president, has answered that call and will be an important force in galvanizing the positive voices for continued improvement in corporate governance.
Some of the other ideas emerging are not so market friendly as they would increase costs significantly without any demonstrable benefit. As I travel around the world talking with users of Cayman Islands financial services, the issue of rising prices is frequently mentioned as a concern.
These users perceive that as the industry transformed from HNWI to institutional users, service providers grew less concerned about competitive pricing, yet ironically institutional users are more likely to be price sensitive because of public accountability and tremendous pressure to increase profitability to drive share prices.
Further moves by service providers to increase profits under the guise of ‘regulation’ may push our users past the tipping point and create opportunities for our competitors in ways never previously imagined. Business history is littered with examples of the hubris of promoters who overestimated the price elasticity of demand for their otherwise excellent products. This fragile balance is very easy to destroy.
Every profession needs to renew itself. We are continually doing this at dms – adapting, learning and growing. The independent director profession is transforming from a cottage industry to a bona fide profession – from the kitchen table to the boardroom – into a profession now too important to be considered simply ancillary to providing administration, legal or investment management services. All can flourish in these changing times, but it does take the right ideas and the right motivation.