Worldwide: The Carne Hedge Fund Governance Series – Issue 5: Operational Functions Of Fund Boards

Last Updated: 2 December 2014
Article by John Ackerley


This is the fifth issue in the Carne Hedge Fund Governance Series and examines some of the critical operational functions that should be overseen by fund directors.

Following the Weavering Case and general calls for better corporate governance standards as a result of the financial crisis, the Cayman Islands Monetary Authority ('CIMA') published a Statement of Guidance (SOG) on 13 January 2014, setting out the minimum governance standards for directors of funds registered with CIMA.

The SOG sets out the key corporate governance principles for both the "Governing Body" and "Operator" of a Regulated Mutual Fund. The terms "Governing Body" and "Operator" are synonymous with the board of directors of a company, the general partner for a limited partnership or the trustees of a unit trust. The SOG is intended to be in line with international governance practices as well as codifying common law principles, including many of those set out in the Weavering case.

Fund governance best practice calls for hedge fund directors to take a proactive role in overseeing critical areas such as middle office functions, broker/bank account opening and closing, cash and security reconciliations, control over fund payments, cross trades management, oversight of delegates, side letter control and valuations and securities pricing. This briefing also includes a discussion of the operational policy documentation funds may be expected to have in place.

Operational Functions

Middle Office Operations – Middle office operations are increasingly being outsourced, transferring the responsibility for regulatory compliance and support to third party service providers with the primary aim being to both reduce operational risk, standardise processes and address the demand for enhanced oversight. The fund board should take appropriate steps to assure themselves that these functions are delegated to an appropriately experienced third party professional services company, with ongoing monitoring of their functions by the board through, for example, the provision of periodic reporting.

Broker/Bank Account Opening and Closing – The fund board should take appropriate steps to ensure it is aware of all accounts in the name of the fund. One way is to include an express provision in the investment management agreement covering independent controls for cash movements, including designating authorized signatories and instituting specific procedures to deal with the opening and closing of broker and bank accounts.

Cash and Security Reconciliations – Fund managers should adopt procedures or processes for clearing and settling transactions and for wiring funds. The fund board should have sight of such procedures and regularly make enquiry of the manager and administrator to ensure that these procedures are followed. Moreover, the fund board should request reports from the fund manager and administrator relating to the reconciliation of positions and cash accounts across counterparties (and the frequencies of those reconciliations), such as prime brokers, futures commission merchants, administrators, and front office, including prompt resolution of trade breaks, errors and failed trades.

Control over Fund Payments – Control over the fund's bank account should lie with the fund's administrator. The administrator should be responsible for screening invoices and submitting them to the fund manager for final approval. A second screening process should occur before final payment. Directors of the fund board should be able to verify that there is no sole control over the fund's bank account by the manager. While the directors should not need to approve every invoice, some managers have taken this step and involve directors (who are authorised signatories) in the final release of payments from the fund's account, providing copies of invoices being settled together with wire instructions for execution.

Cross Trades Management - The trading of securities between two or more funds or between a fund and a fund manager must be monitored as suchtrades can result in price manipulation or the placement of inappropriate securities in portfolios. A conflicts policy should be implemented to outline how transactions between accounts will be managed and priced so that investors are not disadvantaged. In some cases managers have adopted an advisory committee to consider and approve these transactions. It is increasingly the case that such an advisory committee will be comprised of a majority of disinterested individuals, including independent directors who sit on the boards of the offshore funds that the fund manager advises. Advisory committee members are typically charged with reviewing all such transactions to ensure, among other things, that:

  • transactions are effected at a fair market price;
  • the transfer of investments is appropriate for both the transferor and transferee;
  • the rationale behind the trade is clear and reasonable;
  • no party to the transaction appears to be disadvantaged; and
  • the allocation of securities is consistent with the fund manager's general trading policies.

By properly documenting each transaction, fund boards can demonstrate that a conflicts process is employed before trades are completed and fund managers can evidence that they are dedicated to ensuring the fair and equitable treatment of all of their investors.

Oversight of Delegates – The fund's selection and monitoring process for its service providers should take into consideration each service provider's independence and control over its activities. For example, the Cayman Islands SOG expects fund directors to (i) regularly take steps to satisfy themselves that a fund's service providers are monitoring compliance with the SOG; and (ii) request appropriate information from service providers and/or professional advisors to enable them to satisfy themselves regularly that it is in compliance with applicable laws, regulations, rules and statements of principle, statements of guidance and anti-money laundering or combatting terrorist financing requirements. Additionally, the fund board shall also provide appropriate directions to the service providers to rectify any such non-compliance. The fund board should also require regular reporting from the fund's investment manager and other service providers to enable them to make informed decisions and adequately oversee and supervise the fund.

Side Letter Control - Keeping track of side letters and ensuring that the terms contained therein are complied with becomes particularly problematic if the fund has entered into numerous side letters with a variety of different terms and conditions. In particular, managing "Most Favoured Nations" (MFN) clauses can be difficult for managers to monitor on an on-going basis. It is therefore important that managers have in place proper governance of side letters to ensure that the fund does not breach the terms of such letters, for instance, by entering into a new side letter with an investor that provides rights or benefits which are more favourable, in any material respect, than those previously agreed with a side letter investor. Best practice for the fund is for the manager to establish a side letter register containing all of the relevant terms of each side letter executed which should be updated regularly, monitored and compliance with such terms recorded. This compliance log should also be monitored periodically by the directors through enquiry at meetings.

Valuations and Securities Pricing - The pricing of securities is perhaps the most obvious area where a fund manager could be subject to accusations of bias given the typical compensation structure of most funds. As such, it is best practice to avoid any perception of bias in the valuation of assets. This can be achieved by implementing a valuation policy which requires that the administrator provide independent pricing for the portfolio. Where this is not possible (i.e., in highly illiquid investments where the fund manager is often best placed to value the assets), additional checks and balances should be used to provide an element of independent oversight. For example, the rationale for the pricing method or model used by the fund manager might require approval by the board of directors, and any departure from that model require further approval. A clear valuation policy that is available to and approved by the fund's directors or advisory board will provide further reassurance that the portfolio is being appropriately priced. To take this a step further, some fund managers are asking independent directors to attend internal valuation committee meetings to ensure that the policies are being consistently applied.


With fund boards and the role played by directors under more scrutiny from investors than ever before, it is critically important that fund directors follow best practice when overseeing critical operational functions around the fund. This includes a heightened awareness of fund operations that are particularly exposed to actual or perceived conflicts of interest. Directors must periodically assess the management of operational procedures in an objective light in order to provide elevated levels of assurance to investors that the operations of the fund are being adequately monitored for operational effectiveness and equitable treatment of investors.

Previous editions of the Carne Fund Governance bulletin are available on the Carne blog.

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.

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