IMDDA Post - Industry Insight
When a hedge fund is revealed as fraudulent, or suffers a serious operational failure, many institutions will immediately scrutinize the corporate governance structure. Usually, weaknesses in this area are not difficult to miss and common failings may include conflict of interest such as familial relations sitting on the board, or a demonstrably under-skilled and inexperienced individual acting in a directorship capacity. Nowhere was this better illustrated than in the collapse of the Weavering Capital hedge fund in 2009.
Nowadays, most institutional investors will be able to easily identify whether a director possesses a conflict or is lacking qualifications through a quick Google or LinkedIn search. If it is not spotted in this crude initial due diligence, it will generally be picked up in any on-site visit by the operations team. But some believe another challenge exists, and that is the prevalence of individuals occupying enormous numbers of directorships, an issue that repeatedly crops up in offshore hubs such as the Cayman Islands, but also in certain onshore markets too.
Quantifying the exact numbers is very difficult as the information is not in the public domain, but some reckon certain directors sit on just shy of 1000 individual fund boards. Directors – often ex lawyers, accountants, fund administrators or custodians – may have an impressive understanding of hedge funds, but investors are skeptical they possess the bandwidth to sit on so many boards. This concern is justified as directors are fiduciaries, and are supposed to represent investor interests, particularly if a manager goes into default or is discovered to be on the wrong side of a regulatory investigation.
Many directors were found wanting during the financial crisis. The ease at which managers were able to instigate gates or suspensions led to furious exchanges with investors, who questioned precisely what the directors did to protect their interests. Improvements have been made and investors are at least probing deeper into what directors do. A few allocators have even created blacklists of directors whose involvement in a fund will be met firmly with an investment veto. Such individuals will usually be singled out for their board participation at a hedge fund which failed or was found to suffer serious regulatory or operational shortcomings.
The corporate governance issue came to light recently with the collapse of the Platinum Partners hedge fund, which subsequently saw several of its top executives charged with criminal acts by the US authorities. DMS, a well-known professional services firm in the Cayman Islands, acted in a directorship capacity for Platinum Partners, until resigning after the fund manager refused to provide it with information about some of its decisions, including why it opted to change auditor arbitrarily, according to an article by Reuters. Following DMS’ resignation, it reported Platinum Partners to the Cayman Islands Monetary Authority (CIMA), who subsequently contacted the Securities and Exchange Commission (SEC).
By all accounts, DMS did the right thing, and the organization has repeatedly said it is not facing litigation. But DMS is an example of a firm whose directors sit on a significant volume of boards, and the Platinum Partners escapade has reignited debate in the institutional investor community as to whether this is an appropriate model.
How should Institutions approach corporate governance?
There is no right or scientific answer about how many hedge fund boards any director should sit on. Proponents of the so-called “jumbo” directorship model articulate the industry is so diverse, that it is wrong to be prescriptive about numbers. This is a fair point. A director sitting on the board of an insipid long/short equity hedge fund is unlikely to be too stretched by the role, versus someone overseeing the workings of an emerging market debt fund. Put simply, it is more feasible for a director to sit on a greater volume of boards if the hedge fund strategies are fairly vanilla.
The problem for investors is that extracting information sometimes from providers of corporate governance about their capacity is not an easy task as many directors cite confidentiality laws for not disclosing the number of boards they sit on. There is also no searchable public database of directors in the Cayman Islands, although reforms by CIMA did require directors to register privately. Again, a deep dive of directors’ workloads and their ability to act as reliable fiduciaries is tricky.
A more fundamental issue is whether directors should remain on the board in the event of a fraud or suspected fraud. In the case of DMS, the directors resigned and that is something they are perfectly entitled to do. But one expert said that a board – provided there is no evidence of involvement in the fraud by any director (s), should remain in place as they hold a fiduciary duty to the end investors. He added though it would be sensible to replace the chairman and bring in an external independent so as to ensure investor safeguards are maintained.
Many investors are willing to tolerate the presence of one or two jumbo directors sitting on their hedge fund boards. This is ultimately a decision driven by cost. An experienced individual prescribed to sitting on a limited number of boards will cost between $30,000 to $50,000 per year, versus $5000 to $10,000 charged by a jumbo director. Returns at hedge funds have not been strong, and investors want to make every basis point (bp) count.
Skimming on costs does have consequences. If a fund fails, investors tend to have little recourse against directors in offshore jurisdictions. The Cayman Islands sets a very high bar as to what constitutes “gross negligence”. For example, the Cayman Islands-based directors at Weavering Capital had their initial $111 million fine dismissed as the court determined there was insufficient evidence to show they had intentionally breached their fiduciary obligations. As such, it is crucial investors conduct due diligence on directors and they should make any reservations they have known to the manager.