USS IM cajoles hedge funds to behave better

Corporate governance initiatives gain traction with funds and investors

uss-awards
Daniel Summerfield (left) and Luke Dixon, USS

Not every institutional investor can claim to have had a profound impact on the evolution of the hedge fund industry. Arguably, USS Investment Management, the investment arm of the Universities Superannuation Scheme, is one.

USS is the second-largest pension scheme in the UK, with assets of more than $42 billion. The majority of assets are managed in-house by USS Investment Management, a wholly owned subsidiary of USS.

Just over five years ago, USS Investment Management embarked on a crusade to push for better corporate governance of hedge funds. Luke Dixon, co-head of public market manager selection, together with Daniel Summerfield, co-head of responsible investment, have been campaigning for better behaviour, not only from managers, but also from directors of hedge funds.

“Institutions have been really influential in the evolution of the [hedge fund] industry for the right reasons,” says Dixon. Since the financial crisis, the majority of money flowing into hedge funds has come from institutional investors. Dixon believes the power of the chequebook gives long-term investors – such as USS Investment Management – more leverage to help change the overall image and running of hedge funds.

“We can focus on things like fees, governance and alignment of interest more so than many asset allocators. Commercial asset managers are often more motivated to negotiate additional capacity or higher liquidity rather than lower fees. And if they start jumping up and down on a soapbox, they’re going to get managers turning them away.”

Both Dixon and Summerfield have been on the proverbial soapbox, championing stronger corporate governance for hedge funds, less woolly language in fund documents and more dialogue in general with investors about the structure and running of funds in which they want to invest.

While both admit it has been a hard slog, a breakthrough came with a 2011 judgment by the Grand Court of the Cayman Islands (financial services division). The judgment kickstarted a judicial discussion of the scope and extent of directors’ duties in the hedge fund industry. This has inevitably led to a reconsideration of appropriate standards and gave USS Investment Management’s campaign a fresh lease of life.

The court found the directors of the liquidated Cayman-domiciled Weavering Macro Fixed Income Fund guilty of wilful default in the discharge of their duties after an investigation (later abandoned by the UK’s Serious Fraud Office) into allegations of fraud against Weavering Capital, the UK manager of the fund. The directors were the brother and stepfather of Weavering Capital’s chief executive and managing director.

The Weavering judgment was the first time directors of hedge funds were instructed to take their job seriously, notes Dixon. It was also an attempt to codify and define the role and responsibilities of directors. “We saw some pretty woolly practices in fund governance. We’ve been campaigning for improved governance for five years now and in the early years that message often fell on deaf ears. A lot of managers had never heard concerns raised about governance before. But Weavering changed that,” says Dixon.

What the industry needs is to eliminate bad headlines, believes Dixon. For example, generally the only headlines that concern hedge funds in the popular press relate to fraud and greed: two things that hit everyone’s hot buttons.

“Hedge funds are unlikely to elevate themselves to a place of prominence in institutional portfolios and thereby make a bigger difference in investors’ performance unless the industry’s image improves,” he says.

“There’s too much negative perception about the investment and reputational risk of hedge funds among trustees. The easiest way to improve the industry’s image over time is to augment governance. It doesn’t cost a lot of money. It’s a false economy to save money in the quality and number of directors.”

Both he and Summerfield believe funds need to pay good directors, particularly those that agree to limit the number of their engagements, which “allows them to pay attention to each engagement that they have. With improved governance we should limit the instances of fraud that tarnish this industry,” concludes Dixon.

“A lot of investors woke up to the fact that the buck stops at the board. Investment managers don’t own the fund. It’s the directors who oversee it and if anything goes wrong and the proverbial hits the fan, it’s the directors that are in the firing line, particularly when there is litigation,” says Summerfield.

When USS decided to focus on this issue, Summerfield explains, the main concern was the number of directorships an individual held. Not only were there historical reasons for people to hold a large number of directorships, but no attempt had been made to articulate what the roles and responsibilities of a director were. “That didn’t stop anyone from taking on positions. All you had to do was tick a couple of boxes,” he says.

Once investor flows had shifted from friends and family offices to institutions such as USS, the role of directors came into sharper focus. A string of court cases in Cayman and the British Virgin Island courts – the two jurisdictions where the vast majority of offshore hedge funds are domiciled – further emphasised the need to employ competent directors as well as individuals who have the time to devote to a fund if anything goes wrong.

However, attitudes take time to change. A market grew up around companies that provide offshore directorships, but these were really providing rubber-stamping exercises. Some individuals sat on the board of hundreds of funds and no one thought anything of it.

There was also a cultural difference. “There is a very different mind-set in the US,” explains Summerfield. “There it is about running the business.” Engagement with shareholders – or, as in the case of hedge funds, investors – is not emphasised.

“You have very poor access to corporate management and boards in the US. Whereas [in Europe] it’s very much ingrained in the whole DNA that investors in the company have access to the management as long as you are an appropriate size. There is also a level of accountability. It is countercultural to the US funds. If you’re setting up a fund with a US manager, the manager and lawyers are generally reluctant to allow investors to have many rights. The whole general/limited partnership structure doesn’t necessarily lend itself to good governance,” he adds.

The master/feeder fund structure preferred by most managers also presents other challenges. Summerfield believes that structure “doesn’t lend itself to good governance. In Europe the commingled funds, with the board at the top, are much easier.”

“However, we’re moving on. There has been 20 years of development of governance within Europe, whereas in the US it hasn’t quite got through the legal barriers that shareholders have significant rights and documents should be structured that way,” he adds.

For Dixon the issue is clear: good corporate governance will help avoid fraud and professional malpractice. “If you have good governance, you will hopefully have fewer incidences of criminality within the hedge fund industry. With fewer negative headlines overshadowing the valuable contribution that hedge funds can make in institutional portfolios, hopefully sponsors and trustees will be more willing to allocate capital to the industry.”

Key to shifting attitudes was getting regulators onside. Summerfield led several missions to Cayman and met with the Cayman Islands Monetary Authority (Cima). Putting together a loose coalition of similarly minded pension funds and institutional asset managers from the UK and North America has helped change minds. This ‘global coalition’ represents around $60 billion invested in hedge funds, the majority of which are incorporated in Cayman. The first formal investor delegation to Cima arrived in March 2013 and was followed by a second in April this year.

While the group welcomes recent initiatives by Cima, such as the statement of guidance and registration of directors, Summerfield and others want to push for more improvements. The impetus is also a function of the boards of trustees of many institutional investors that want assurances that Cayman, as the world’s leading offshore hedge fund jurisdiction, is providing a prudent operating environment for investing money.

Significant progress has been made, with the introduction of the Directors Registration and Licensing Law this year. Both the group and Cima are aware of the need to avoid over-regulating or introducing prescriptive measures, but at the same time want to raise standards and improve disclosures to investors. Several key issues still need to be addressed, most notably the introduction of a director database for Cayman-based funds.

This database needs to be comprehensive and searchable by director so investors can view an individual’s current and past directorships. Investors also want to see the database used as a tool to verify information provided by directors. Therefore, it should include not just the appointments held by an individual of Cayman-registered entities, but also all other appointments.

Summerfield admits there was a “significant lobbying effort to get others on board” with the Cayman initiative as well as in promoting good governance more generally. He sees Cima as receptive, mainly because it is also under pressure to demonstrate that it is a jurisdiction that is setting best practice.

“Forces have come together to push the regulator to take action and although it did take a long time for the regulator to acknowledge the fact that it needed to do something, it has now embarked on a consultation and implementation phase to improve governance requirements of funds incorporated in Cayman,” says Summerfield.

While applauding the measures already taken, Summerfield says the investor group is calling for a compliance regime with a higher level of standards where directors will all have to explain to what extent they comply with best practice. “We’re still working with the regulator on that. At the moment it’s a basic level of best practice. We think we could raise the standards a bit higher.”

Dixon adds: “If the industry doesn’t make these changes itself, the regulation that will eventually get pushed down by bureaucrats will be bad because there are always unintended consequences that flow from even the best-intended regulation. That’s going to be bad for the industry. It’s going to increase costs and limit choice. We don’t want that. We just want an adequate level of disclosure, a high level of understanding by each participant in the industry of what’s required of them and the disclosure to allow us to do the appropriate level of due diligence in order to make better-informed investment decisions.”

He firmly believes it is in the best interests of managers and investors that the “industry’s game gets raised to a point that the bad headlines go away, with the result that there’s a lot less scrutiny from regulators and politicians on our industry”.

“Give us the tools to do the job because we’re capable of doing the job ourselves and finding a market-based solution. We do not advocate a ‘let’s regulate everything’ approach. We’re pushing against over-regulation because we think that’s probably going to result in bad outcomes for investors,” Dixon adds.

A prime example of this is the alternative investment fund managers directive (AIFMD). Although it has significantly changed since its initial drafting, Dixon argues that it was – and is – not necessarily a good solution for the industry.

“You can’t regulate for good behaviour,” adds Summerfield. “That’s what regulators always fail to understand. That is what we want to avoid in Cayman. We like the principles-based approach and to its credit Cima doesn’t want to over-regulate.

USS Investment Management has communicated “encouraging noises” to Cima to say the new statement of guidance “is a good start but it needs to be at a higher level to capture best practice as opposed to codifying existing practice. That should be part of the next stage of development,” continues Summerfield.

The next battle will be for the disclosure of the number and names of directorships held, and an explanation of how an individual intends to discharge his/her responsibilities as a director.

“You leave it to the director to explain. One of the mistakes we made early on was to set a number [of directorships] and that became a hostage to fortune. As soon as you put out a number, it’s the number that is debated. One could be too many for someone. There is no hard and fast rule.”

For Dixon it is transparency: a certain level of disclosure allows him and his team to have informed discussions with directors.

Another area Dixon and Summerfield are keen to tackle is fund documentation, something that links well with the push for better practices by directors of funds. “Without the appropriate documentation – the articles and the private placement memorandum (PPM) – you won’t have the appropriate governance framework. Even the best board will serve little to no purpose if the documents are poor,” Dixon adds.

Equally, in the past there was little scrutiny of documents. “It wasn’t that long ago that very few investors even read the offering memorandum from front to back,” he says. “When you started reading the documents and getting into the details, some pretty alarming things came to light.”

USS Investment Management has been a vocal advocate for the past five years that a description of the strategy and the associated investment restrictions should mirror the strategy as described and marketed by the manager. “This seems obvious but most fund documents are made from boilerplates. The reality is that if you redact all the names from a document and then read it, you’ll be able to say which legal firm wrote the PPM.”

The problem is that the boilerplate approach means that the vast majority of PPMs allow managers to “invest in anything anywhere in any size and concentration they want with some possible exceptions, usually imposed by Irish Stock Exchange listing requirements. That’s it,” notes Dixon.

As a template for monitoring the investment manager’s activities, this is useless, asserts Dixon. “How do you monitor style drift when the PPM allows the manager to do virtually anything? The problem is that these documents were drafted by and for the manager, to maximise their investment flexibility and control. Seldom, if ever, is there any investor input and fund directors have generally done a poor job ensuring that fund documents balance the interests of managers and the rights and interests of [future] investors.”

Most documents are drafted and signed off long before the first investor is contacted. Rarely are investors able to provide input into the drafting of the fund documents. “Directors have an obligation to ensure the fund is appropriately structured, that the documents are supportive of external investor interests,” says Dixon.

He thinks there are around six versions of the ‘boilerplate’ created by each of the leading law firms in the industry. They are very similar and a third of the language is purely about indemnification for decisions taken.

“Is it right managers should have this amount of discretion? Who is overseeing them?” asks Dixon.

Instead, Dixon would like to see documentation for commingled funds closer to the fund-of-one documentation that he uses at USS Investment Management.

“We believe these documents are actually in the investors’, directors’ and managers’ interests, and are fairly balanced. In most commingled fund documents, those interests are not balanced. In a typical PPM, virtually every clause favours the manager by granting it control, discretion and flexibility,” he says.

“Ultimately, it is about improving the industry. If we don’t get it right, regulators will impose rules and regulations that have adverse consequences for investors and the broader industry. Investors should be the key influencers over fund development because without investors there is no hedge fund industry.”

USS Investment Management was the recipient of an award for outstanding contribution to the European hedge fund industry at Hedge Funds Review’s European Single Manager Awards 2014.

 

Corporate governance makeover for Cayman

The Directors Registration and Licensing Law 2014 was passed in Cayman in April and came into force on June 4.

The law is designed to help the Cayman Islands Monetary Authority (Cima) verify basic information on directors of companies it regulates as mutual funds and companies registered with Cima as “excluded persons” under the Securities Investment Business Law (2011 revision).

Under the law, Cima is able to regulate ‘professional directors’ and ‘corporate directors’ of covered entities.

The law is relevant to any person who is or intends to become a director of a company that is or will be a covered entity no matter where that person resides.

Every individual that is a director of a covered entity will need to be registered with Cima or licensed as a professional director by the regulator. If an individual sits on the board of 20 or more covered entities, the professional director licensing regime will be relevant instead of the registration regime.

Cima has also issued responses to industry questions raised during the consultation process regarding the registration and licensing regimes under the law.

For “natural persons” who are directors of less than 20 covered entities, the registration requirements should be straightforward and will involve submitting certain basic information to Cima and paying an initial application and registration fee. Cima expects registration applications to be processed within 48 hours.

The information required to be submitted will be limited, but will include the person’s name, date of birth, nationality, home address, email and telephone contact details, as well as the names and registration numbers of the covered entities for which they act as a director. Cima will maintain a register of this information but the register will not be open to the public.

Cima is required to maintain a register of directors of covered entities separately from the proposed public database project, which the regulator announced in January 2014 in conjunction with the release of its statement of guidance on corporate governance for regulated mutual funds.

 

Weavering impact

The court held that the Weavering Macro Fixed Income Fund’s independent directors should exercise a “high-level supervisory role”.

In essence, this means directors need to satisfy themselves on a continuing basis that various service providers are performing their functions under the terms of their contracts and that no managerial and/or administrative functions that ought to be performed are left undone.

The judgment detailed numerous facets of this role.

For example, directors must satisfy themselves there is an appropriate division of function and responsibility between the investment manager and administrator. Directors must also satisfy themselves the fund is complying with investment restrictions set out in the offering documents. In addition, directors must acquire a proper understanding of the financial results of the fund’s investment and trading activity so they can conduct inquisitorial enquiries of the administrator and auditor appropriately when reviewing financial statements before they are approved.

In the Weavering case, it was found that the directors consciously chose not to perform their duties to the fund in any meaningful way while also knowing perfectly well that their behaviour was wrong. These are extreme findings of fact. The directors in question would have failed any test for the due performance of their duties.

The judgment raised the bar for all but the most diligent directors of hedge funds. It requires them to undertake new responsibilities at three potential phases in the running of a fund – establishment, ordinary course of business and crisis management.

For example, at the establishment stage a “desktop review” of service provider contracts was said to be insufficient. It is the directors’ duty “to stand back, review the various contracts and satisfy themselves that each one is appropriate and consistent with industry standards”.

During the ordinary course of a fund’s business, minutes of board meetings should “fairly and accurately record the matters which were considered” before recording any formal resolutions that are passed. However, a detailed description of board discussions or debates would go beyond normal practice for many companies in other jurisdictions and may cause concern about the generation of discoverable documents recording a fund’s innermost workings.

In the Weavering judgment, the court did indicate that directors were entitled to rely on the fund’s administrator and auditor to use reasonable skill, care and professional judgment in preparing financial statements and conducting audits of those statements. But it is not entirely clear on what directors can safely rely, as the judgment also states it is “their duty to exercise an independent judgment in satisfying themselves that the financial statements do present fairly the fund’s financial condition”.

The judgment also stated that administrators and auditors “are entitled to rely upon the directors to perform their role”. This begs a number of questions about the question of third-party claims in situations where a number of actors are involved in the preparation, issue and approval of financial statements which turn out to be wrong.

One view is that a critical review of directors’ conduct should focus on their supervision of the process by which other service providers perform delegated functions, rather than ascribing responsibility for the content of what those service providers produce as a result.

If directors ask the right questions of the various service providers concerning the effective discharge of their functions, the directors should be entitled to rely on the answers being provided in “an honest and professionally competent manner”, as the judge said in Weavering.

Another issue concerns the differences between ‘non-executive’ and ‘independent’ directors. The Weavering judgment applied principles from English jurisprudence concerning the duties and liabilities of non-executive directors of conventional trading companies.

However, there is an argument that the scope and extent of the duties of independent directors of hedge funds should be different to a degree. Hedge funds are entirely and uniquely outsourced businesses, which attract investors explicitly on that basis.

Hedge fund subscribers consider they are investing in the skills of the manager identified in the offering memorandum and, while they want to know that the board comprises or contains independent directors, their decision to invest is unlikely to be governed by the identity of those directors.

Then there is the question of fees charged by independent directors. The Weavering judgment suggested the amount of such fees “should be commensurate with their responsibilities, and time and attention which must be devoted to discharging their duties”.

It is not clear quite how the judge intended this proposition to work in practice, although he did not allow the fact that the Weavering directors charged no fee at all to reduce the scope of their duties.

An independent director fee of $25,000 a year (towards the top end of the scale of fees charged by professional directors in the Cayman Islands) might be said to equate to approximately four hours of work a month at an hourly rate of $500. It is questionable whether the judge in Weavering would regard that sort of time commitment sufficient. The effect of this judgment could put upward pressure on independent directors’ fees.

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