Previously published by AIMA Journal
It will come as no surprise to market participants that there has been increased worldwide demand for better, more conflict-‐free corporate governance of investment funds; a primary objective being improved investor protection. One approach to addressing this objective has been a wider role for regulators; while many believe stronger regulation is vital, other observers identify inefficiencies and failures of such an approach.
This article focuses on another (somewhat less debated) approach that may run in parallel to regulatory provisions, tackling industry demands at the source; namely, at the fund structuring and corporate governance level.
Regulation should offer a demonstrable value in keeping with the costs that are created through its existence.
INVESTOR PROTECTION THROUGH REGULATION
Recent history demonstrates that regulation alone is slow to produce 1, cumbersome to live with, expensive 2 and regularly fails 3. Even now, the next fund/regulatory meltdown is within sight based on the investment from unqualified investors into what would normally be considered 'qualified investor' strategies; 'NEWCITs' circumvent established law and one can only guess how long it will be before the next media and politically driven uproar occurs following vulnerable investors' loss of money in investment schemes which they didn't understand. It would therefore seem that no level of regulation will ever, or should ever, be considered as being 'fraud proof'.
The remainder of this article will thus consider ways in which better corporate governance and oversight could be achieved within the fund industry's existing infrastructure, beyond the separate debate centred on increased regulation.
An area of fund governance often overlooked is the effective control of the corporate vehicle itself; a straightforward review of the position of the fund's principals and those of the investment manager may be one of the most under-considered and yet important issues for investors. Such a review may be extremely productive as a means of minimising non-market based risk.
It has long been the case for many investment funds that the principals and directors of an investment manager control the board of both the investment manager and the fund itself.
Such structuring creates a significant conflict of interest given that the directors of the investment manager have a fiduciary obligation to act in the interests of the shareholders in the investment management company whereas the directors of the fund have a fiduciary obligation to act in the interests of investors.
Although conflicts of interest are normally disclosed in the fund's offering documents, removal of a conflict is better than disclosure. Removal of conflicts such as drafting of balanced agreements between investors and investment manager or the extent to which a manager can devote time to other projects is key; as soon as subjective factors exist, there is greater pressure on everyone, not only to act in accordance with their fiduciary duties, but also to be seen to have done so. An independent fund enables the manager to focus on what it does best.
Whilst the appointment of independent directors to the board of the fund is undoubtedly part of the solution to this conflict, it is still rare to see a fund board comprised exclusively of independent directors. Moreover, where this does happen, it is normal for such independent directors to be capable of being 'hired and fired' by the same individuals or entities that control the investment management company. It is therefore reasonable to conclude that whilst the use of independent directors is a valuable step it may not present a complete solution.
The ongoing conflict raises two other points:
1. A consideration of the extent to which Director liability can be limited within the law (i.e. how much flexibility a fiduciary might have in a conflicted situation where a duty is owed to different parties with very different interests);
2. and How to create and operate fund structures that grant independent directors greater freedom and demonstrable independence from the investment manager to exercise their authority in favour of investors.
Whilst a detailed consideration of fiduciary liability and the extent to which it can be limited for professional fiduciaries is beyond the scope of this article, readers can gain some insight into this issue with reference to the leading case of Armitage v Nurse 4.
In summary, so long as a fiduciary acts in good faith they can limit liability very substantially through express words in core documents (and, in some cases, by obtaining evidence of informed consent). Whatever one's views on the 'rights and wrongs' of the extent to which liability can be minimised, it stands to reason that enabling a director's interests to remain as unfettered as possible when acting in the interests of investors is key.
Given the regulatory challenges and conflict of interests, we're left in search of a more pragmatic approach to improving investor protection, namely by structuring investment funds in such a manner to address the conflict of interest without adding to the regulatory burden.
Although not compulsory in many cases from a regulatory perspective, many investors (particularly institutional) are demanding the appointment of an independent, properly regulated fund administrator (a 'Qualified Administrator'). As a result of having the right systems and the right employees, a Qualified Administrator is often in the best position to provide services that are accurate, independent and conflict free. Inevitably, greater independent oversight increases investor confidence and helps funds to raise money. Independent Directors are also now largely appointed for similar reasons.
It is now time that the industry take the next step towards better corporate governance through the wider use of independently held funds (for the purposes of this article, 'Independent Funds'). In doing so, the conflicted position of the investment manager's principals exerting control over the fund and its service providers is eliminated and the fund operates with a range of service providers with independent systems and focus according to the law, the offering documents and the interests of investors.
A simple way for managers to demonstrate the utmost good faith to their investors is to seek a structure within a well-managed series-entity company where the voting/management shares (i.e. the non-economic shares) are held by a company affiliated to the fund administrator or other party that is independent of the investment manager.
Legislation concerning series entities (identified by a number of different names such as 'Segregated Portfolio Companies', 'Protected Cell Companies', 'Segregated Accounts Companies' or informally as 'umbrella companies') is now well established in most fund jurisdictions. Within such structures, numerous strategies ('portfolios') can exist while each portfolio's assets and liabilities remain entirely segregated; there is no recourse to the assets held by other portfolios under the same umbrella company 5.
Umbrella companies can offer a cost-effective solution, as well as potentially reducing the compliance burden. While the due diligence procedures for the founding portfolio of a new umbrella company may be as substantial as for a 'standalone' fund, further portfolios of the same umbrella company often have a far smoother account opening process where the same bank/custodian/prime broker etc. are used, even though entirely separate accounts are created.
Similarly, in cases where the 'independent structure' is sought, but a series entity is not appropriate or perhaps where substance for the fund in a given jurisdiction is required, there may be potential for a trustee to hold the management shares as an independent fiduciary.
Whatever one's view on the efficiency of regulation (existing or planned), a fund supported by as many independent service providers as possible adds substantial safeguards for all parties to it. All other things being equal, a more independent fund will be less contentious and easier to attract investors to. Moreover, umbrella companies play an increasing role in enabling Independent Funds to be established. Independent Funds are not a change in direction, rather a natural evolution of the efficient and positive progress that the industry continues to make alongside the demands of the prevailing regulatory environments in which we all operate.
1. For example, the European Commission proposed its original draft of the Alternative Investment Fund Managers Directive (AIFMD) on 30 April 2009. After years of negotiations and around 2000 amendments to the original draft, the Directive will final enter into force at European Union (EU) level on 21 July 2011 and member states of the EU will then have a further 24 months to transpose the Directive into national law.
2. For example, with respect to the implementation of the AIFMD, it has been reported that the directive will cost the private equity and hedge fund industries in the EU between €1.3bn and €1.9bn in the first year, with an annual recurring cost thereafter estimated at between €689m and €985m (www.ft.com/cms/s/0/251c682e-‐a63d-‐11de-‐8c92-‐00144feabdc0.html#axzz1Rsaptew7).
3. For example, the Luxalpha fund, a feeder for Bernie Madoff's fraudulent operation, as well as several others, had been certified as a UCITS fund. Despite being subject to rigorous EU regulation, the lack of harmonisation across member states concerning the role of the depositaries meant that the Luxalpha fund generated losses of approximately €1.4 billion through its custodian, the Swiss bank UBS (see further Weber, R. And Gruenewald, S."Fraud – UCITS and the Madoff Scandal: Liability of Depositary banks?"(2009) 6 Butterworths Journal of International Banking and Financial Law 338).
4. (1997) EWCA Civ 1279. Readers should bear in mind the normal definition of'Gross Negligence' now requires some form of bad faith which has generally changed since the case was ruled upon.
5. In order to safeguard segregation there are a number of key 'rules' to follow, it is crucial that the holder of voting gshares understands these considerations and sticks to them; the authors can be contacted to discuss them.
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.