The board of directors play a central role in any offshore hedge fund. At every stage of the life cycle of a hedge fund the directors need certain critical information and documents in order to perform their duties. The life cycle can roughly be determined as the fund formation stage, the post launch operation (which might last several years) and then the eventual liquidation.
This brief article outlines what a hedge fund director will expect when they are appointed to a fund. In addition, consideration will be given to choosing hedge fund directors and their activities.
FUND FORMATION AND SET UP
During the fund formation and planning stage for a hedge fund one of the considerations is to decide which directors to appoint and the composition of the board. There are a number of considerations when choosing directors, which will be discussed briefly here.
One of the main drivers behind considering which director or directors to appoint is where they are located and also, where they conduct their business from. In many jurisdictions the tax authorities, in considering the tax domicile of a fund as opposed to its legal domicile, not only look at where the entity is formed (e.g. Cayman Islands or BVI), but also where the effective management and control resides. In order to ensure that the effective management and control does not result in unintended tax consequences most hedge fund directors will be located in an offshore location such as the Cayman Islands. In addition to ensuring the directors are located offshore, it is also important that the directors conduct their activities in a location such as the Cayman Islands. If Cayman Islands directors were to hold every meeting in London or other similar jurisdiction, there would be a strong inference that the hedge fund is controlled from such jurisdiction and not the Cayman Islands and this may then be create certain tax consequences. Depending on the situation, a hedge fund board may be composed partially with directors located in an offshore jurisdiction with the remainder being onshore, the latter being appointees of the manager or strategic investor. Whilst there is no hard and fast rule on the composition, care should be taken depending on the jurisdictions involved to structure the composition correctly. Offshore hedge funds with onshore board directors will normally still ensure that all board meetings and material decisions are taken outside of any jurisdiction where their could be tax consequences.
One of the issues central to the Weavering case in the Cayman Islands (see the link here to a previous article on this: http://www.mgcayman.com/weavering-case/), was whether the directors were experienced enough to sit on the board. In addition, there were other issues including the relationships with the manager. When selecting a hedge fund director experience is critical to ensuring that proper oversight is achieved. If the director has no relevant industry experience then this can be red flag to investors and regulators that lip service is being paid to proper oversight. Evidence of professional qualifications and experience should be sought from directors (such as being a qualified accountant or lawyer). Directors should also be asked if they are willing to show independent thought and fully understand directors' duties and investor protection. The directors should also have a good working knowledge of corporate law and the mutual fund laws and regulations of the jurisdictions the hedge fund operates in, as well as a good grasp of international issues affecting hedge funds. It should also not be underestimated that directors should be accessible and responsive rather than simply waiting to see what the fund's manager or lawyers advise. As investment vehicles hedge funds are some of the most dynamic in the world and therefore being able to access directors on a regular and sometimes urgent basis is critical in forming an opinion on the suitability of the directors. As directors are acting in a personal capacity it is also important to look at their skills and experience in isolation, as well as in addition to, the attributes of the organization they work for.
With increased scrutiny and due diligence it is becoming more common for directors to have some form of service agreement or contract setting out the terms upon which they will act in addition to the Funds Articles of Association ("Articles") which will set out the indemnity provisions. While it is not mandated careful consideration should be given to considering entering into a written agreement with a new director.
In the first board meeting the directors will be asked to address a number of issues including approving the prospectus or other offering materials, material agreements to be executed, bank accounts to be opened, the appointment of the investment manager, brokers and custodians and other issues such as signatories on bank accounts and the initial offering period. The directors accept personal liability for a material misstatement of any offering materials they approve and therefore great care should be taken in reviewing them. The directors should undertake basic steps to ensure to cross-reference the Articles and the offering document to ensure conformity on the key terms such as redemption procedures. The hedge fund industry works on the basis of fair disclosure to investors careful consideration is required to ensure the offering documents accurately reflects the Articles.
D&O
The majority of larger hedge funds will provide directors and officers insurance ("D&O")for the directors of the fund. There are many benefits to doing this and often the main benefit to the fund is overlooked, namely that the D&O in the majority of cases benefits the investors. If in the unlikely event a hedge fund has litigation, the D&O policy can normally be used at least in part to fund a defense as opposed to using investors monies. If there is no D&O policy then the directors may seek to rely on indemnities under the Articles. In addition, the directors should ensure that the D&O policy obtain is a first recourse policy to ensure that it is applicable before the hedge funds assets.
POST LAUNCH - CONDUCT OF BOARD MEETINGS AND OVERSIGHT
It also goes without saying that directors should ensure that a proper quorum is available at the commencement of a board meeting and that the proper parties and reports are available for their consideration. Adjournments or follow up meetings and calls may be required if people of information are not available. In addition, all board meetings should be conducted in accordance with the Articles (e.g. it may stipulate notice requirements, quorum, limitation on the directors' powers etc). One of the most asked questions is in what frequency should board meetings be held and if any should be held in person. In forming an opinion on frequency and format for the meetings there are a number of considerations including how active the fund is, whether there are special issues needing oversight and the requirements of investors and other stakeholders. Invariably board meetings will be held to approve audited financial statements, which would dictate at least annual meetings. For most hedge funds, however, annual meetings will be insufficient and quarterly or even more frequent meetings may be appropriate.
It is absolutely critical that oversight by the directors is not simply a rubber stamping exercise or that the directors view themselves as acting as "nominees" for some other party such as a manager. Any professional hedge fund director who is properly experienced, and has sufficient time to devote to their appointment, will make sure that board meetings are comprehensive and substantive and not merely a papering exercise or "going through the motions". Hedge fund directors need to be able to way up legal advice, the commercial aspects of a transaction and situation and balance this with their duties to the hedge fund and investors. This may mean challenging advice or recommendations that they do not agree with.
For routine matters it may be appropriate to use written resolutions (e.g. a waiver of a redemption notice period). However, again care should be taken to make sure in whatever format is followed that active consideration is given to the conduct that is being approved and that the draft minutes as presented are followed with proper consideration and alteration if required.
In a crisis situation, the role of the directors becomes of essential importance. Examples may include a loss of assets through fraud or neglect by a broker or manager, a market crisis resulting in a liquidity crisis for the fund or other external event impacting the fund, such as litigation. In those situations, the directors decisions can have drastic consequences for the funds and its investors and therefore each issue must be carefully analyzed and considered, ensuring that the directors conduct their duties diligently in accordance with their fiduciary responsibilities. It may be necessary for the board to seek legal advice independent from other service providers.
Ensuring full information and disclosure to the Directors is critical. The Directors will expect at each board meeting to see regular reports from the service providers to the hedge fund. This will include reports from the Administrator and Investment Manager. It may also include reports from custodians and banks and brokers. The Directors should also request to see copies of any investor letters or complaints. As was shown in the Weavering case, the directors received the reports but failed to duly consider them or question them. It is important that the directors consider the completeness and accuracy of the reports and question any gaps or inconsistencies. It is also important that conflicts of interest are fully disclosed and addressed.
The regular attendance of the directors at board meetings is extremely important. Only by attending the meetings on a consistent basis can directors develop a good picture of its ongoing operations. It should also be noted that the Articles may require the removal of directors for failing to attend a specified number of meetings.
SIDE LETTERS
The majority of hedge funds will be asked to enter into a side letter. The side letter can of course be used to facilitate a large investment or to attract a strategic investor. The entering into a side letter will raise various fiduciary and other concerns that must be addressed by the director. A director should not be afraid to raise questions where a side letter term which is clearly offensive to the funds Articles or simply unsavory (please see prior article published in that regard http://www.mgcayman.com/hedge-fund-side-letters/).
INVESTOR PROTECTION
Since the global financial crisis most hedge funds investors are conducting due diligence on the manager and its principals. However the independence and quality of the directors should also be carefully evaluated. In particular the investors will want to ensure that the director is sufficiently competent and experienced so that if they have to make difficult decisions they will do so in the best interests of all the investors whilst not favoring one group of investors over another. In addition they should not simply following recommendations from legal counsel or the manager.
RESIGNATION OR REMOVAL
For various reasons a Director may resign or be removed from a board. In such cases, it is important to follow the correct formalities.
If a director voluntarily resigns he or she should ensure that a letter of resignation is submitted. If the removal is made at the insistence of the other directors (e.g. for non-attendance at board meetings) or investors, then this may require a vote of voting shareholders. It is crucial to follow the correct procedure. It may also be advisable to advise investors of the change of directors. The prospectus for the fund should be updated as soon as possible. In the same manner, when a new board appointee is elected, the fund documents should be updated to reflect this.
LIQUIDATION
If all goes well (or not so well) a decision to liquidate the fund may be taken. The directors will play a role in this in that they will execute the declaration of solvency in a solvent liquidation. The directors will need to be satisfied as at that date that the fund is solvent for a certain period (usually 12 months). The directors will take personal liability in the event such declarations prove to be untrue and therefore they should undertake to receive proper information from the administrator, manager and in some cases the auditor.
One of the difficult areas in a liquidation is whether or not the fund still has illiquid assets or is subject to litigation or claims. These issues may prevent or delay a liquidation. The directors need to carefully review and weigh-up whether it is better to simply proceed with the liquidation rather than continue to incur the costs of any problem areas prior to commencing the formal liquidation procedure.
SUMMARY
It is impossible to write a comprehensive guide of what is expected of a director and the role they will perform with respect to each fund, as no two hedge funds and directors are the same. Directors have to approach each engagement with a certain amount of flexibility and take the time to understand the hedge fund they are appointed to. There are, however, some basic requirements that a director should exhibit, including experience, independence, competence, performance of their fiduciary duties, diligence and allocation of sufficient time and resources to perform their duties.
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.
