Independent directors and non executive directors have come into the spotlight in recent years following the well reported failings of firms such as Weavering Capital. In earlier examples, Beacon Hill Asset Management and Bear Stearns High Grade Structured Credit’s offshore fund directors were singled out for criticism for failing in their duties.
So what exactly is the role of the independent director and what duties should they carry out?
This increased focus and awareness of the role of independent directors has led to many regulators taking a closer look at recruitment procedures and appointment requirements, and the Cayman Islands Monetary Authority is no different.
In the UK, the Corporate Governance Code states that an independent director should be:
“Independent of management and free from any business or other relationship which could materially interfere with the exercise of their independent judgement.”
In many offshore jurisdictions there has been a long standing de minimis regulatory requirement for non executive directors to be registered with the competent authority. In these jurisdictions the potential to be struck off a register acts as a natural force in policing the quality of directors.
Plans for corporate governance
In January this year, CIMA outlined its plans for corporate governance in a consultation paper issued to private sector associations and other interested stakeholders. Within this consultation, the regulator suggested the creation of a public database of funds domiciled on the Islands which would include details of directorships for each fund. From this consultation it is clear that the regulator is making a consolidated move towards creating greater accountability and transparency in the corporate governance of offshore funds, particularly hedge funds.
So what has driven this call to action from the regulator, aside from increased public scrutiny? The two most obvious areas are the rise and increased interested in global corporate governance due to well publicised failings; and the widening scope of the traditional due diligence process, coupled with an increasingly savvy investor.
In context: Global corporate governance
Independent directors face increasing global challenge with a raft of regulatory changes impacting the hedge fund industry. We are seeing institutional and high net worth investors undertaking due diligence on directors and on fund structures and the fund professionals with whom they work.
Low investor confidence and a series of high profile corporate governance failures have led to global regulators, such as the FSA, SEC and Hedge Fund Standards Board, placing corporate governance and the role of senior management high on their respective agendas.
In many European jurisdictions regulators have started to crack down, where they have previously taken a more relaxed approach. One example of this new found approach is in Luxembourg, where the Commission de Surveillance du Secteur Financier (CSSF), now probes all directors and considers a number of factors, including whether or not directors are spread too thinly across funds to deliver effective challenge to the fund manager.
Currently, if independent directors have more directorships than the CSSF is comfortable with (this can be as little as five), they may block would-be directors from taking on any more.
Expanded focus for due diligence
Due diligence is another area in which hedge funds are facing greater scrutiny from investors. Typically, the core focus on financial due diligence is being augmented with targeted due diligence on directors and operations, as well as the managers within a fund. We have certainly found this to be the case, with a number of clients asking for a more detailed analysis of directors.
This can include reporting on their understanding and knowledge of the fund; their input into the strategic direction and investment strategy; as well as the directors’ understanding of the regulation and compliance requirements for the fund.
Whilst individual interviews with would-be directors are not commonplace, it would not seem beyond the realm of possibility for a greater number of investors to want to meet the individual directors responsible for the corporate governance of the fund in which they are investing as part of their due diligence process.
Directors are also required to show that they are adding value and providing the level of security required by investors. Questions will be asked around the level of activity a director has; the access they have to pertinent documents that dictate the investment strategy; and the influence they have into ongoing activity to provide sufficient challenge to the board if required.
Additionally directors that are perceived to be less engaged with the fund and who are not considered to be actively involved may not have sufficient ‘power’ to challenge the status quo and probe the board for answers on behalf of investors.
This is likely to be flagged as a governance issue. An example of this could be the issuance of a Net Asset Value (NAV) report that may look odd, triggering a query. A highly active director will have the insight and ability to question the board and probe the reasons as to why this is the case. Can the same be said for a less active director without the right level of understanding and knowledge of the fund?
Developments in corporate governance
This new found scrutiny, however, has not come as a shock to the industry and it is not being approached from a standing start. Offshore fund boards have become increasingly professional in the last five years following the financial crisis with, directors now being appointed to meet certain skill sets for the benefit of the business.
These include risk management, due diligence, auditing and internal controls or portfolio management. In addition, we are now seeing that the majority of board members are independent of both the investment manager and of any other service providers. This trend suggests we are seeing the rise of a new breed of director, one that should devote sufficient time, effort and attention to the corporate governance of the fund to satisfy the needs and requirements of investors.
With a greater interest and focus on the part of investors, it appears that the anecdotal stories of fund directors with hundreds of directorships may be something of the past. It is increasingly accepted that so many directorships would mean that one person could never dedicate sufficient time to the companies of which they are directors.
This shift towards more active and involved directors, devoting time to the fund, attending board meetings and actively playing a part in the development strategy has, so far, been well accepted.
Additionally, as directors are under more scrutiny there are even suggestions being put to some firms that directorships are for a set period, with re-appointment necessary after a set time. If this is to become common practice then it is likely the number of directorships an individual undertakes diminishes, with potentially fewer boards’ members but an increase in skill sets and the possibility of an increase in remuneration.
CIMA suggestions and the impact on fund directorships in the Cayman Islands
By creating a centralised database for directorships in the Cayman Islands, this would appear to create a level of certainty for investors and regulators alike. The increased level of transparency would require potential directors to submit personal contact details and information on their specific role within the board structure. They would also be required to show that their experience matches that of the role requirements and that they have significant knowledge within that particular sector.
The consultation, which asked for responses by mid March, puts forward quite a considerable change in the way that independent directors of offshore funds are selected and regulated, particularly as there are few current regulations in place regarding directorships.
If successful, it could see the Cayman Islands follow the lead of the onshore world with each region maintaining a code of conduct as to the expectations of an independent director. However, if the regulator does not implement stringent policing procedures, the consultation will have little or no bearing on actual behaviour.
The era of increasingly professional corporate governance of offshore funds has now come of age and the influence of fund managers and promoters is now more effectively checked. The move by CIMA, added to the Alternative Investment Management Association’s offshore alternative fund directors’ guide released in 2008, could well see a concerted move towards a global code of conduct for independent directors and global regulators working more cohesively.
It is a likely evolution that offshore directors will need to seek professional advice to stay abreast of their own duties and to keep up with global regulatory and market change. This could in turn lead to a requirement for bespoke training and development for potential directors, including the creation of a tool kit or guide outlining the requirements of offshore directors.
For investors and fund managers, questions that will need to be asked include:
- Are they sufficiently close to the issues, the risks and the onshore regulatory agenda? For example, how do they now advise the boards on the new regulations in Europe?
- What impact will AIFMD have, and how will this affect a range of issues, from marketing to remuneration?
One day, perhaps not too far away, investors will expect their advisors to meet key directors and ‘look them in the eye’ to make due diligence efforts even more personal.
Until then, the move towards greater accountability and increased transparency can only be a positive step for the offshore hedge fund industry and change the misguided reputation it has garnered in recent years.