Originally prepared for the Cayman Financial Review January 2009 Edition.
"Most CEOs..you would be happy to have as trustees for your children's assets..too many of these people, however, have in recent years behaved badly in the office, fudging numbers and drawing obscene pay for mediocre business achievements. These otherwise decent people simply followed the career path of Mae West: "I was Snow White but I drifted."
(Warren Buffett, Berkshire Hathaway Annual Report, 2002)
Recent corporate scandals, shareholder activism, media criticism and a call for the review of legislation have caused a re-examination of the role and accountability of directors. As a result, directors have become increasingly active in their oversight of corporate activities but, as more eyes focus on the board, it has become correspondingly more difficult to recruit qualified independent directors. The following article explores what is meant by the term "Independent Director" and to review issues facing board members.
What is an Independent Director?
There has been much debate of late as to the relevance of a professional code of conduct for independent directors. Interested parties have argued that formal identification of the role of an independent director within an investment fund together with clear guidelines regarding the amount and type of information that should be available to such directors is more relevant. There is dissention amongst those well placed to comment as to the amount of interference and responsibility that an independent director should shoulder and opinion is split between the non-interventionist approach advocating a responsibility for the fund that does not extend to active oversight of the service providers and those who believe that independent directors should behave more akin to internal auditors or compliance officers, responsible for the review of management activity; compliance with investment objectives and the review of marketing material so as to ensure that all investor groups receive equal and adequate information.
Attempts to promote a more efficient board by requiring several committees composed of independent directors have been encouraged by legislation such as The Sarbanes-Oxley Act but there appears to be no correlation between independent directors and board performance as directors remain dependent on management for rewards and reputations.
In January 2008, the Alternative Investment Managers Association re-published its Offshore Alternative Fund Directors' Guide (the 2008 Guide) recommending that,, in order to be considered properly independent, a director should have no executive function with regards to the fund's investment manager, investment adviser or affiliated companies. Alternatively, a director may hold an affiliation but have no responsibility for carrying out work on behalf of the fund. The writer recommended in an article released in July 2008 that the 2008 Guide should be complimented by a clear and transparent code of conduct and a conflict of interest code to be adopted by every fund board.
This was followed in October 2008, by the establishment by the Cayman Islands Directors Association (CIDA) of a code based on the Code of Professional Conduct for Chartered Directors issued by the Institute of Directors in the United Kingdom.
Several developments in the U.S. have recently occurred regarding director independence. In August 2008 the SEC and the New York Stock Exchange approved amendments to the definition of "independent director" under the NASDAQ Stock Market Rules such that the threshold of accepted compensation at which a director or an immediate family member will no longer be considered independent has been raised to US$120,000.
Independence has become an essential element from an investor expectation perspective, as well as with regard to relevant listing rules. Such rules clearly impact the makeup of any board as requirements become more stringent, with the majority of stock exchanges requiring that every listed company has at least 51 percent of the board as independent or the creation of a supervisory committee.
The United States Government Accountability Office January 2008 Report1 (the GAO Report) outlines the steps taken by the US Securities and Exchange Commission to oversee hedge fund advisers by appointing examiners to inspect the typical activities of advisers. One of the areas in which the examiners focus is that of the activities of boards of directors for offshore funds and the fiduciary duties of such board members to the shareholders of the funds and consistent disclosure to investors.
The best practice interpretation of independence may be expanded to require that the director has no other direct or indirect involvement with the fund or its service providers or advisers. There must be a question whether the fund's legal counsel (or employees of its service company) can properly qualify as independent. Also, can someone who sits on the boards of multiple funds sponsored by the same investment manager and who generates significant income from those positions, still be considered truly independent?
Conversely, is someone who guards his position as an independent, to such an extent that he restricts contact with the promoter and/or manager of the fund, running the risk of becoming out of touch and uninformed? Where does the balance lie and, once identified, is such a balance possible to achieve?
What are the basic duties and responsibilities of the Independent Director?
Noting that there may be some distinctions between jurisdictions, a director has a duty to act in good faith and in the best interests of the fund and to exercise due care. He must act loyally and should not exercise his powers for an improper purpose nor misapply the assets of the company and ensure there are no conflicts of interest. All powers should be properly discharged and approved and there should be no secret profit from his position as a director.
As the present financial situation shows, boards are under continued pressure to perform but some argue that the fault lies with systemic behaviour encouraged by capitalistic supply and demand dynamics, together with the demands of shareholders that profits be maximised by whatever means. Greed and irresponsibility on the part of a director can be relied upon to maximise returns in the short term, even if disastrous in the long run.
Conflicts are becoming increasingly difficult to avoid as the complexity of the average fund means that service providers often provide a mix of services such as fiduciary, administrative and legal services, albeit with different hats and talent pools which consist of limited numbers.
How should Independent Directors apply such principles to an offshore fund?
Good independent directors should satisfy themselves that the fund is properly structured and transparent to investors; has the necessary checks and balances in place; has made the proper disclosures to investors and regulators and is legally compliant. They will ensure that systems are in place so that they are made immediately aware of material issues that arise with respect to the fund. They will be actively involved in addressing problems, such as regulatory investigations. Regular and substantive reports and board meetings are essential.
There is an expectation that a director owes a duty to the fund on whose board he serves in turbulent times as well as times of tranquility but many say the burden now outweighs the compensation.
It is clearly important to the health of the industry that good board members do not feel forced to resign due to the pressure of the increased regulatory burden or personal liability risk. The question is, are the correct procedures in place and are there sufficient numbers of willing and qualified directors willing to step up to the plate?
The key is to maintain a balance between the various interests. Independent directors should be entitled to reasonable remuneration and protection for their services. Equally, they should not be protected from liability if they fail to meet their obligations to the funds (and ultimately the investors) whom they are paid to serve.
Is it possible for Independent Directors to save a fund?
A number of fund boards have been required to assess internal management performance and provide written explanations to shareholders. Written policies have been adopted by a number of prominent boards with a view to promoting better practices and to prevent the fund from violating securities laws and to comply with the constitutional documents. Such policies are often referred to in the fund's private placement memorandum.
Is it fair to insist that directors have a solid understanding of their funds investments and the actual basis of valuation? Increasing the director's role (and fee) may be the answer. However directors to whom the writer has spoken were reluctant to agree to the additional exposure, even for an increase in fee.
Recent case law suggests that U.S. securities laws and regulations will charge directors with the duty of monitoring disclosures and their accuracy. Independent directors who are aware of potential discrepancies will be expected to question, discover and correct or risk being found delinquent in their duties. Independent directors are not responsible for every company statement or securities compliance but those who comprise an audit committee may be held to a higher standard as a reminder that they are considered securities monitors.
In addition to the above, it is agreed that directors do not and should not manage the company on a day to day basis but should act as prescribed monitors of key officers and insiders of the company2.
Disagreement over responsibility for valuation remains a recurrent theme. The employment of an independent director may have ensured that the fund administrators performed independent valuations and not relied solely upon the fund manager's valuations without questioning the valuation methodology.
Directors Accountability – protection for the reckless and willfully negligent?
Some argue that this is the most important question that currently affects directors with the introduction by some jurisdictions of strict limits on directors' exculpation and indemnities.
Does current legislation inhibit recovery by shareholders who have been fraudulently misled? Is legislation required to address fraudulent and wrongful trading and to deal with delinquent directors?
Much debate exists over the requirement to up date the companies law to protect investors in line with recent limitations imposed in Guernsey as currently there are no such limits imposed under Cayman Islands legislation in the absence of fraud or bad faith.
Recent Case Law
Recently, the US Bankruptcy Courts have considered applications by Cayman Islands registered funds for protection under Chapter 15 of the US Bankruptcy Code (Chapter 15). This is essentially an ancillary application to a primary proceeding being brought elsewhere. The US Bankruptcy Court must be satisfied that the primary proceeding is either a "foreign main proceeding" (where the debtor's centre of main interest (COMI) is located or is a "foreign non-main proceeding" (where the debtor has an establishment but no COMI).
The Bankruptcy Courts declined to recognise the Cayman Islands proceedings in any form and found that the funds' COMI was located in the US in the absence of evidence to the contrary. The fact that there were two directors resident in the Cayman Islands and that other ancillary activities took place there, were considered insufficient to support a finding of COMI or even of an establishment in the Cayman Islands.
In light of these decisions, it is possible that, in future, fund directors may find themselves open to question if they have not structured the operations of the funds correctly and ensured that sufficient measures have been taken to ensure that the fund's COMI is clearly offshore.
Prudent investor due diligence requirements increasingly demand effective and demonstrably independent directors and an assurance of a robust action by directors ensuring the fund is properly structured and operated and that the exercise of proactive oversight, over key areas of the funds operations, is maintained, e.g., asset valuations and the ability to swiftly identify, investigate and deal with any deviations.
The role of the independent director is a critical one and of growing importance as the hedge fund industry matures and the investor profile expands. Better standards of qualification are required for board members as too often, company boards recruit those with no specialist experience to carry out their functions or suffer from management cronyism. Director competence should be the primary focus before consideration is given to regulation and oversight.
The actions of shareholders, particularly institutional investors, as suggested by the Myners Report3, should be reviewed, placing some of the burden on the investor to explain what they are doing to demand action from poorly performing boards.
It has been argued that it is for corporate boards to prevent a deterioration of conduct4 and it is the responsibility of the directors to slap the hands of "greedy managers" who overreach and "dip too deeply into the pockets of the shareholders". The recent Lehman Brothers case illustrates the point. Warren Buffet's comments of 2002 are prophetic but the situation appears to be worsening. It may be time for those who serve as independent directors to revaluate their current practices with a view to becoming more proactive and robust in their enquiries as overreaching may indeed have become common with few hands being slapped.
1. "Hedge Funds - Regulators and Market Participants Are Taking Steps to Strengthen Market Discipline but Continued Attention Is Needed". (GAO-08-200).
2. A clear reminder to independent directors of their watchdog role is the recent case of SEC v. Kohavi, Case No. 08-43-48 (N.D. Cal. Sept. 17, 2008) where directors allegedly approved 21 separate back dated option grants and were charged with reckless behaviour.
3. Institutional Investment in the UK: A Review (the Myners Report) was a report to HM Treasury of the United Kingdom in March 2001.
4. Berkshire Hathaway, Annual Report, 2002, p.16.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.