NEW YORK (Thomson Reuters Regulatory Intelligence) – Investment-fund boards of directors have a critical responsibility to be an “independent watchdog” on behalf of investors. For most U.S. retail investors, mutual-fund directors of mutual funds are held to strict standards under the Investment Company Act of 1940 and usually perform as required. However, directors of private funds, that is, hedge funds, often are not truly independent, meaning free from conflict. And often they serve more as a “rubber stamp signatory” with little monitoring or oversight.

Structural problems associated with directors of private funds are reviewed below, in light of a case against hedge fund firm Platinum Partners, where criminal charges were filed against top executives for running the $1.4 billion fund “like a Ponzi scheme.” Some suggestions and best-practice advice for private fund boards of directors are also offered.

TYPICAL CAYMAN PRIVATE FUND STRUCTURE

A common structure of many U.S. hedge funds employs a “master-feeder,” where U.S. investors invest in a domestic limited partnership (LP) or limited liability company (LLC) and foreign or non-taxable U.S. investors invest in a foreign corporation. The foreign corporation is often based in the Cayman Islands, which requires a board of directors. These “feeder funds” invest all or substantially all of their assets into a “master fund” which is sometimes also a Cayman corporation and requires directors.

The benefit of such structure is that the manager only has to manage one pool of assets in the master fund rather than allocating trades and investments side-by-side to multiple feeder funds. The accounting and allocations are commonly done by an administrator and the structure generally works well for most managers.

Some of the advantages of the “master-feeder” structure include; ease of trading because of the elimination of allocating trades, simple pass-through accounting, fundraising flexibility for additional feeders to accommodate future investors, and tax and regulatory flexibility.

The disadvantages include set-up cost, cost of directors and cost of administrators, registrar and transfer agents (RTAs) for the multiple feeders. It is also common to have directors serve on boards of both master and feeder corporations. Often these directors work for one of the large financial-services firms which provide various services to the industry. The directors also provide their services to multiple funds.

This is where potential conflicts of interest can arise; the service firms often provide accounting services, RTAs, and directors to the private funds.

Furthermore, a director can sometimes serve on as many as 100 different fund boards. The practice of using independent hired foreign directors has increased significantly since the 2008 financial crisis, in an attempt by managers to shield personal liability. However, it has raised concerns that some independent directors hold so many board seats that they lack the requisite time to effectively fulfill their obligations. A relative handful of Cayman “jumbo directors” are sitting on the boards of hundreds of hedge funds.

By comparison, the vast majority of U.S. mutual fund directors work with just one company, according to the Mutual Fund Directors Forum. Corporate directors serve on an average of 1.5 company boards at once, according to the National Association of Corporate Directors.

CAYMAN REGULATORY OVERSIGHT

The Cayman Islands is a tax-friendly British overseas territory nestled in the Caribbean. In an attempt to address some of the oversight concerns, in 2013 the Cayman Island Monetary Authority (CIMA) issued a non-binding “statement of guidance” (here) for its more than 10,000 funds.

The guidance sets out best-practice principles and establishes minimum governance standards for governing bodies of funds. It does not impose a strict or all-encompassing code of conduct on governing bodies or operators of funds; rather it establishes an overall framework for good corporate governance within which funds should operate. It also does not impose specific restrictions on investments, risks or strategies, nor does it attempt to direct, prescribe or constrain the management or business activities of funds.

The guidance covers other areas including:

— Oversight functions

— Conflict of interest

— Number of board meetings per year (minimum of 2)

— Record keeping or minutes of meetings, oversight of contracts and terms of service providers

— Communication with fund investors and standards for offering materials.

In 2014 CIMA imposed the Directors Registration and Licensing Law which set registration obligations for directors of registered mutual funds and certain securities investment businesses. Licenses are required for “professional directors” appointed to the boards of 20 or more covered entities, and “corporate directors” of covered entities.

Despite the tighter standards the director business remains robust and the island remains the preferred jurisdiction and domicile for U.S hedge funds. It remains difficult to hold Cayman directors responsible for hedge fund collapses or failures. Indemnity clauses in their contracts usually require investors to prove they acted with “gross negligence” — a high hurdle.

PLATINUM PARTNERS’ CAYMAN DIRECTORS

The New York-based and now bankrupt Platinum Partners (here) is the subject of multiple criminal and regulatory investigations and arrests (here) and has been the subject of a number of Reuters News (here) and Regulatory Intelligence articles (here).

Executives named in the case have pleaded not guilty.

Platinum drew five of its six independent directors from firms in the Cayman Islands. What is less clear is whether those directors could have prevented Platinum’s decline.

Donald Seymour and David Bree of Cayman-based DMS Governance Ltd were directors for Platinum’s troubled Value Arbitrage Fund. They are among the most prominent practitioners of what critics call the “jumbo” model – where professional directors sometimes sit on hundreds of boards at once.

After U.S. authorities arrested Platinum executives in December and charged them with running a $1 billion fraud scheme, some investors asked DMS founder Seymour what happened, people familiar with the situation told Reuters.

In response, Seymour sent a mass email to investors and consultants in January saying the firm was “very proud” of its Platinum work, according to a copy seen by Reuters. He said DMS was not the subject of any related litigation or government investigations and had in fact helped the SEC in its probe of Platinum.

Spokesmen for the SEC and Platinum, whose executives pleaded not guilty, declined to comment.

Still, some hedge fund investors who spoke to Reuters in recent weeks expressed a wariness of directors serving too many clients.

DMS directors worked for feeder funds and a person familiar with the situation said they were unaware of the extent of Platinum’s alleged wrongdoing, which includes illegally transferring money between funds, dramatically over-valuing assets and cashing out some investors ahead of others.

DMS pushed Platinum to provide more information and questioned some of its decisions, such as changing its auditor, the person said. When Platinum failed to comply, DMS resigned and reported the firm to the CIMA, which in turn contacted the SEC, all months before any charges.

A similar scenario played out with three directors from Cayman-based HF Fund Services, another firm that provides independent directors for hedge funds and other financial companies. The men, Brian Burkholder, Patrick Harrigan and Richard Coles, worked for feeder funds of Platinum’s Credit Opportunities Master Fund, which is expected to recover much of its assets.

The trio resigned last summer after a longtime Platinum associate was arrested in connection with a political bribery scandal (here), a person familiar with the matter said, but they had no knowledge of Platinum’s alleged fraud.

HF Fund Services, whose directors work with about 30 clients each, said in an emailed statement that it had no relationship with Platinum’s now-bankrupt Value Arbitrage Fund. The issues of control between feeder and master funds amount to a “governance gap” and should be addressed through alternative structures, HF said.

In the case of Platinum, the board likely fulfilled its obligations and duties under CIMA, and DMS may have even gone the extra mile to contact the SEC when suspicions arose. However, the question remains, should DMS have done more and perhaps sooner to potentially detect the alleged fraud. And, would a similar fraud have occurred under a mutual-fund type structure and governance? The answer to that questions is likely no.

BOARD BEST PRACTICES AND SUGGESTIONS

The Cayman Islands are just one of the many jurisdictions where funds have chosen as their legal domicile. In Europe, funds also sometimes opt for Luxembourg and Ireland. Other choices include British Virgin Islands, Bermuda and the U.S. state of Delaware. Each has its pros and cons and unique benefits or disadvantages for funds.

Independent directors usually meet at least twice a year with hedge fund personnel and service providers to review operations. While they have the mandate to ask hard questions, they still face serious constraints.

As a director of a feeder fund, they may have limited visibility to the activity in the master fund and are essentially acting on behalf of a pass-thru shell. Firms and directors should take steps so that this is not the case and directors are given line of sight into all of the activities within the fund structure for which they serve.

Furthermore, directors need to consider other activities of the adviser so that there is adequate oversight of any and all potential conflicts of interest.

Directors and firms must also be careful to disclose any director conflicts as well as mentioned above. Often paid independent directors are affiliated with firms that provide other services to the fund and adviser. Such conflicts must be monitored, mitigated if necessary, and fully disclosed.

Fund directors must act in the fiduciary interest of investors, thus all boards should include directors who are unaffiliated with the fund (independent directors). The right mix and number of directors and independent directors should be carefully considered and should not be determined simply by cost or location.

Often fund directors are seen as an afterthought or plumb positions for friends or are chosen from lawyers, auditors and custodians linked to the fund. Firms must take the board selection seriously and investors should exercise care and do their due diligence before investing in a fund without a properly structured independent board.

With the heightened scrutiny of directors serving on too many boards, fund sponsors should not be afraid to ask the question how many boards a potential director is serving. The exact acceptable number of boards is open for debate but a common sense approach is warranted and such due diligence is necessary.

Lastly, while fund directors do not need to customize and test a compliance program, they must have a high level of familiarity in order to properly identify potential failures. It’s a director’s responsibility to ask tough questions and not be overly complacent. Although fraud may be difficult to detect, directors must be on the lookout.

(This article contains material from Reuters News)

(Todd Ehret is a Senior Regulatory Intelligence Expert for Thomson Reuters Regulatory Intelligence. He has more than 20 years’ experience in the financial industry where he held key positions in trading, operations, accounting, audit, and compliance for broker-dealers, asset managers, and hedge funds.)

(This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Mar. 20. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters)

IMAGE: A traditional light bulb with carbon filament is displayed at a do-it-yourself store in Dortmund August 31, 2009.

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