Independence of fund directors and material conflicts of interest
Every day we wake up to news about trade wars, terrorism, natural disasters and major political events that all greatly affect our personal lives and the investment world. There are also serious issues facing the fund governance industry which cannot be avoided but can be managed by the funds industry. Change cannot be escaped and within the funds industry, change must occur sooner rather than later for it to thrive.
Karl O’Reilly (pictured), fund director at IMS discusses the independence of fund directors, which is a key consideration when selecting independent directors of Cayman Islands funds.
“Last year, I spoke about the importance of the residency of the fund directors. Since then, there have been some high-profile funds were the independent directors were not truly independent and the issue around conflicts of interest has come to the fore once again. Here, I outline my thoughts on the current board composition and the significant conflicts of interests that remain in the funds industry.
Institutional investors are taking a more proactive approach in reviewing the directors of hedge funds, so it is essential that investment managers take the appointment of directors very seriously. Currently, the common composition of a fund’s board is to have three directors typically consisting of one from the investment manager and two independent directors. The majority of a fund’s directors should be free from any conflicts of interest. The investment manager will naturally have a conflict of interest which will be clearly disclosed in the offering memorandum and will be disclosed at each board meeting. However, best practice dictates that employees of the investment manager should not have the majority of votes at a board meeting. Therefore, they will not have the power to make any decisions which are not in the best interest of all investors and this can help prevent/manage potential conflicts.
A practice that continues to be inadequately addressed by the market, to its detriment, is the continued appointment of directors from the fiduciary arm of some offshore law firms who act as legal counsel to the fund. In my view, this is a very material conflict of interest which should be avoided by all funds and especially avoided by newly launching funds. The industry has listened to the weak arguments of the offshore law firms regarding the appointment of directors from its fiduciary arm; the magical information barriers and the great efficiencies that will benefit the clients to name a few. This conflict of interest is very significant and is a clear red flag for investors. It should be avoided by investment managers setting up funds and attempting to attract investor capital. A fund should not have its entire board conflicted; this then makes the entire concept of a fund’s board and its independent directors potentially ineffective and redundant. Due to the common ownership of the fiduciary arm and the law firm, this a very clear and obviously a material conflict of interest. A true ‘independent’ director comes in to his or her fore, with their review of the documents which is designed, among other things, to spot any material items of conflict or concern. A director acting for the fiduciary arm of the law firm that assisted in the drafting of the fund documentation may not be as inclined to raise issues which might conflict with drafting advice provided by counsel.
During a financial crisis, the advice of any law firm to the directors must be in the best interests of all the investors in the fund, especially not to a single investor or the investment manager. We should quickly remind ourselves that one of the key parts of a director’s role is the protection of all investors interests by exercising oversight of the activities of the fund and its service providers. Only truly independent directors can act on such advice from all industry experts and act impartially at the required times to effectively prevent or manage conflicts. There is no issue/conflict of interest with the offshore law firms providing administration services such as registered office, FATCA/CRS and board support services along with acting as legal counsel to a fund.
In relation to investors, to avoid any potential conflict of interests, no single investor should have the ability, directly or indirectly, to appoint their preferred independent directors, unless it’s a single investor vehicle. Investment managers may face problems later down the road when attracting institutional investors. They may recognise the material conflict of interest as an obvious red flag and will more than likely request a change of directors before allocating capital to the fund. It is best practice to avoid material conflicts of interest from inception, so all investors can see that an investment manager has displayed a high regard for fund governance since inception of the fund. Since the financial crisis, generally, the administrators have continued to not allow their staff to act as independent directors on funds where they also act as the administrator. This practice has been strongly encouraged by the market and reflects a desire to avoid material conflicts of interest. Friends and family members of the investment manager (a la Weavering) should never be considered as independent directors. This is an obvious red flag for investors, although potentially difficult to detect.
The Cayman Islands government is in the process of introducing the Mutual Funds (Amendment) Bill, 2020 and the Private Funds Bill, 2020 (together the “Bills”) which will strike a balance in strengthening investor confidence and ensuring the Cayman Islands remains the jurisdiction of choice for the formation of investment funds. With such a desire from the leaders of the country to enhance its reputation, it should be expected that industry participants look in the mirror and ask themselves some serious questions on this important fund governance issue. If the funds industry wishes to grow sustainably over the long-term, then we must act quickly and embrace the concept of continual improvement of our standards, with the aim of removing material conflicts of interests from all fund structures. The investment manager and its onshore advisors should ensure that the fund structure, the majority of its directors and the service providers are truly independent of each other.
My advice to investment managers launching their fund in a difficult market environment would be to take the time to appoint qualified and experienced independent directors who are truly independent of all service providers. This will result in an effective board in which the investors can have a high degree of confidence. My advice to investors is to inform the investment manager and its advisors that they will only invest in a fund that represents a new era in raising the bar of fund governance.”
Fund Director, IMS
Karl O’Reilly is a fund director at International Management Services Ltd. (‘IMS’), one of the leading providers of governance and directorship services to the investment fund industry in the Cayman Islands.