HARBOUR It is important that a fund’s directors include individuals with no


conflicts of interest, and there are pros and cons to selecting them from some of the more obvious sources of candidates. Philip Dickie and Greg Bennett explain.


Imagine that you are watching your team play in the finals. An


incredibly close match is ruined in the final minutes by a dubious call from the officials, which costs your team the win. Now imagine that the officials had been appointed by the other team. No matter how impartial they may have been, or tried to be, you will always question whether their loyalties played any role in that call.


The fund industry is made up of many interested parties, both active and


passive, often with competing interests. To follow our analogy, a fund’s directors are officiating the game—ensuring that it flows in accordance with the rulebook and making the tough (and sometimes unpopular) decisions that determine the outcome. With such responsibility, the question often arises as to who should perform this pivotal oversight role for a fund.


It is normal for all parties to want to protect their individual interests,


but if their presence on the board of directors results in a real or perceived bias it may agitate other parties who feel that their interests are at risk of being prejudiced or disregarded. It is not necessarily the case that the parties in power will impinge on the rights of others, but perceptions can create the appearance of impropriety and could lead even the most rational person to believe otherwise.


A good example is the 2011 case of Weavering Macro Fixed Income


Fund v Stefan Peterson and Hans Ekstrom in the Grand Court of the Cayman Islands. In this case, the fund’s directors were the brother and stepfather of the portfolio manager, and they had clearly been selected to protect the portfolio manager’s interests. Not all situations involve such blatant nepotism, but peeling back the layers will, in many cases, reveal other, less overt, conflicts of interest.


A fund typically has no employees, opting instead for a coordinated


interaction of specialist service providers to carry out its business. As a corporate body, a fund can act only through its agents—primarily the directors. Under the laws of the favoured fund domiciles, a director’s fiduciary duties to a fund include those of loyalty, care, and good faith. These duties are owed to the fund as a whole, not to any individual shareholder, creditor, or service provider.


As Justice Jones rightly pointed out in his ruling on the Weavering case: “Directors owe fiduciary duties to their companies to act bona fide in what they consider to be the best interests of the company … and not to place themselves in a position where there is a conflict between their personal interests and their duty to the company.”


It is important, then, that the composition of a fund’s board is selected


in such a way as to avoid possible conflicts of interest that could interfere with their loyalties to the fund. To the extent that it is possible, directors should be independent of all other stakeholders who are in a position to influence, or benefit from, the actions of a fund. A director with mixed loyalties represents, in the best case, a minor inconvenience to the board, but in extreme cases he or she can be a severe impediment to its effective operation. The director may have a moral hazard and be forced to choose between two conflicting forces. In such cases, if individuals are employed by a service provider, they may feel compelled to side with their employer, or defuse the situation by resigning from the board— neither of which is an acceptable outcome.


When selecting a board it is important to engage individuals with the


necessary skill and experience, but it is equally important to consider where their loyalties lie and whether they are, in fact, independent of all interested parties. A board should always comprise a majority of directors who are truly independent.


Administrator appointments Proponents of having a representative from the administrator


point out that such an arrangement enhances the board’s access to information and knowledge of administrative processes. This argument can be effectively countered, however, as there is a good supply of independent directors with previous experience in fund administration who do not work for the current administrator, and are thus not conflicted. It is true that a representative from the administrator may bring fund-specific knowledge to the table, but in a properly structured governance model the administrator will be invited to participate in board meetings and share information with the board anyway, so it is not necessary for him or her to have a vote.


Some administrators will supply only members of their senior


management team to serve as directors, believing that this mitigates the potential for conflict, as they are removed from the actual performance of administrative tasks. These individuals, however, do not have sufficient time to devote to board duties on more than a handful of funds, given their full-time responsibilities to their own firms, and at such a high level it should be presumed that they have an economic interest in the administration fees earned from the fund. Their lack of day-to-day involvement in the fund’s administration also means that they are unlikely to have the granular fund-specific knowledge that would be the primary reason for having an administrator representative on the board.


Mid-tier administrators (representing the majority of firms that still


offer directors) are more likely to have an economic dependence on the fees derived from a large client or group of clients. Individuals with such dependence may not be willing to challenge the investment manager or other board members, or even express their true thoughts, for fear of retribution against their firm.


There may also come a time when the fund chooses to change its administrator. This leads to the question of whether a director should also resign from the board, if his or her firm is removed as a service provider. If so, the fund will not only have the transition of fund administration to deal with, but will also lose crucial board continuity at a time when the fund is going through important changes. The potential negative consequences of appointing an administrator representative far outweigh the potential benefits.


Investment manager The primary purpose of a fund is to facilitate investor access to the


talents of a particular investment manager. Thus, it is common practice to have a representative of the investment manager on a fund’s board, even though many of the concerns related to administrator representatives are


CAYMAN FUNDS | 2012 63


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