When two hedge funds at Bear Stearns Asset Management collapsed in the summer of 2007, investors moved swiftly — but apparently not swiftly enough — to protect their assets. One step ahead of the game, the funds retained accounting giant KPMG to liquidate assets before anyone could wrest control of them. And it did so with the blessing of the funds’ boards of directors. At that time, Bear Stearns Asset Management, a New York–based registered investment adviser — and part of Bear Stearns Cos., which owned investment bank Bear, Stearns & Co. — managed about $45.6 billion of client assets in a variety of investment vehicles, including hedge funds.
But weren’t the directors supposed to be looking out for the people who had collectively put $1.6 billion into the two hedge funds? Yes — under the terms of the rules establishing each fund — but that doesn’t change the fact that it seemed as if whoever paid the piper was calling the tune. The two nonmanagement directors of each five-member board of directors were employees of Walkers Fund Services, one of about 60 Cayman Islands–based firms that provide directors-for-hire to hedge funds. And Walkers Fund Services is a subsidiary of Walkers Group, which includes the Walkers law firm, which had represented the two funds.
A group of 20 investors who wanted to depose and replace both the managers and the board members took the matter to a court in the Cayman Islands, where the funds had been incorporated. The judge allowed them to remove KPMG and hire the Cayman officer of London-based global accounting and auditing firm Kinetic Partners to liquidate the funds in a move that gave investors a greater implied measure of control.
The case was notable not just because the two portfolio managers were charged with securities, mail and wire fraud in U.S. criminal indictments and because the collapse of the two funds was a sign of the broader meltdown to come. It was also a harbinger of a growing unease among many investors over their assumption that hedge fund directors would take their side if push came to shove. As liquidity dried up and markets crashed, many hedge fund managers raised investors’ ire by resorting to survival tactics like imposing lockups and gates on redemptions, side-pocketing assets and restructuring. Directors, who are appointed by the very managers they oversee, have gone along with these measures.
In the instance of the two Bear Stearns funds, the dispute over liquidation was a matter of betrayal, says Jeremy Walton, a partner at Appleby, the Cayman law firm representing the Bear Stearns investors.
“There was criticism of the directors because of conflicts they had, being affiliated with the law firm that set up the fund,” Walton says.
According to corporate law that governs hedge funds in most offshore jurisdictions — among them Bermuda, the Cayman Islands and Ireland — directors are charged with looking after investors’ rights. The sole task that managers have is to attend to investment duties. “Their title is manager, but it’s not their fund,” points out Geoff Varga, who leads the corporate recovery and forensic practice at the Cayman office of Kinetic and is helping oversee the Bear Stearns liquidations.
Then whose fund is it? And is the board of directors where the buck actually stops?
“Directors effectively take responsibility for everything the fund does,” says Steven Whittaker, lead author of the Offshore Alternative Fund Directors’ Guide, published by the London-based Alternative Investment Management Association. The true power, in theory, lies with the board, though in the real world it may not always be so, because directors often have close ties to hedge fund management.
“Finding the genuinely independent person is quite hard,” Whittaker says. “That’s one of the challenges of finding a suitably mixed board.”
Not that the issue of board suitability and independence has ever been a priority for the hedge fund industry. Although hedge fund assets grew by leaps and bounds until last year, boards of directors drew little notice from investors. Managers routinely stacked boardrooms with their co-executives, friends, family and service providers — the law firms and fund administrators with which the fund did business.
“In the old days you’d set up the offshore fund with a wink and a smile,” explains Samuel Weiser, chief operating officer of Sellers Capital Management, a $50 million, Chicago-based long-short equity fund and owner of Foxdale, a due-diligence consulting firm. Weiser says a typical board arrangement would have had a hedge fund manager on the board of his or her fund, alongside a lawyer and an administrator from firms that were on the fund’s payroll. That board would also include one ostensibly independent director based wherever the fund was domiciled, appointed under an agreement that would pay something like $10,000 a year. In fact, the role of “independent director” became a cottage industry over the years, with directors piling on appointment after appointment (Whittaker says he knows of one hedge fund director who serves on 363 boards).
“Those days are over,” Weiser says. “The numbers have gotten too big.”
At the end of March, hedge fund assets totaled $1.33 trillion globally, after peaking at close to $2 trillion before last fall’s market crash, according to Chicago-based Hedge Fund Research. As the hedge fund industry grew earlier this decade — powered by a flood of money from institutional investors like college endowments and pension funds — managers began to hire independent administrators and fund-valuation services to strengthen fund governance and operations. But most have been slow to embrace the concept that directors ought to be given enough independence to look out for the welfare of shareholders first.
Now, in the face of heavy losses, investors are suddenly asking questions about the people who sit on hedge fund boards — how they are chosen and what responsibilities they have. Some managers, however, have stayed ahead of the curve. Among that group is Bruce Berger, chief operating officer and chief financial officer of $4.2 billion,
New York–based Atlantic Investment Management, which as an activist hedge fund firm has more than a passing interest in boards of directors. When Alexander Roepers formed Atlantic Investment in 1988, he installed a British Virgin Islands–based board of paid directors — whose main vocation is to sit on hedge fund boards — to oversee its funds. Once assets grew to approximately $500 million, these career directors were replaced in 2002 with people who had “skin in the game,” in Berger’s words. Today they include high-net-worth individuals, a senior member of a fund-of-funds firm and institutional investors (some of the directors are paid; others decline payment).
Berger sees other firms also moving away from the career-director model and instead appointing investors, academics and other noncareer directors who take the assignment in addition to their day jobs — an arrangement that follows the mutual fund board-of-directors model. “Given what has happened over the past six months, investors are clamoring for it,” Berger says. “It’s just part of good, healthy corporate governance.”
Jane Buchan, CEO of Newport, California–based Pacific Alternative Asset Management Co., agrees with Berger. She recalls recently questioning the stance of an ostensibly independent board member at one of the hedge funds among Paamco’s fund-of-funds investments, together worth $9 billion, after the director sided with the manager in overriding the terms of a Paamco side letter, a mechanism that can be used to segregate and protect an investor’s assets.
“Don’t delude yourself into thinking that because you have a Cayman director who’s a Cayman resident that that director will represent your interests,” Buchan says. She has come to view investors who actually have a stake in a fund as the best representatives of investor interests.
Buchan adds that the fund in question — which she declines to name — holds less than 1 percent of Paamco’s assets, but that the stake was supposed to be placed in moderate to highly liquid securities and that fund managers wrongly switched it into less-liquid ones. Jay Gould, a San Francisco–based lawyer for Paamco, says the case raises a question that hedge fund investors should always ask: “When there’s a problem with a fund, are ‘independent’ directors in a position to provide independence?”
Offshore hedge funds, which are set up outside the U.S. for tax purposes, are typically incorporated under a model that calls for a board of directors to provide oversight, just as all U.S.-based corporations do. And as with U.S. corporations, until a crisis touches off fund-governance questions, investors in offshore hedge funds don’t usually spend much time thinking about who’s on the boards of directors.
A turnabout is in progress now, and investors are beginning to dictate terms to managers, says Russell Read, Boston-based chairman of the Investors Committee of the President’s Working Group on Financial Markets, which in January put out guidelines for best practices for hedge funds.
“The realignment couldn’t have happened during the heady times of the past decade,” says Read, who also chairs the London-based Hedge Fund Standards Board and is a former chief investment officer at the California Public Employees’ Retirement System, the largest U.S. public pension fund, with $165 billion in assets.
Some managers have already moved to make changes. After accounting problems surfaced at the once $5 billion, New York–based hedge fund D.B. Zwirn & Co. in October 2006, for instance, founder Dan Zwirn offered a number of proposals to unhappy investors in an effort to stave off fund redemptions and avoid the liquidation Zwirn is currently undertaking. The firm commissioned an independent accounting review, worked with the Securities and Exchange Commission and laid off 115 back-office workers (D.B. Zwirn at one time had 260 employees). He also brought in a pair of Cayman-based independent directors — one from Athena International Management and a second from DMTC Group — to fill the firm’s only two board seats. (In early May, New York–based Fortress Investment Group announced that it had agreed to take on the management of Zwirn’s now roughly $2 billion in assets.)
“If you have to change directors, it’s a due-diligence red flag,” notes Steven Nadel, an attorney at New York–based law firm Seward & Kissel. But hedge fund directors resign with regularity — and not only because managers are looking to improve their governance profiles. “A lot of these people took on [directorships] because it’s an extra way to make money, but then they realized it’s an extra liability,” says
Greg Wojciechowski, CEO of the Bermuda Stock Exchange, where about 2,000 hedge funds are listed. Legal liability, in fact, is becoming an increasingly important issue for directors, and the proof is in the skyrocketing insurance premiums.
Kyle Kalinich, senior vice president of private equity at insurance giant Aon Corp. in Chicago, reports that premiums on directors-and-officers insurance for hedge funds — policies written to protect directors against lawsuits alleging failure to carry out duties — have increased by as much as 50 percent over the past 12 months. Kalinich says, for example, that a bare-bones $10 million policy for directors at a simple long-short hedge fund strategy with minimal leverage costs about $200,000. For a bigger, and riskier, multistrategy hedge fund based in the U.S., where investors tend to be more litigious than their foreign counterparts, insurance is three to five times greater, costing perhaps $600,000 a year for the same $10 million of coverage.
“The broadest category of exposure is breach of fiduciary duty,” Kalinich says. In late April, Kinetic Partners, the liquidator of the two Bear Stearns funds, sued the fund directors, alleging breach of fiduciary duties. Kalinich notes that investors, not directors, bear the brunt of insurance costs, because premiums are typically paid by the hedge fund.
On rare occasions investor ire can trigger a hostile takeover in a proxy fight. Leslie Lake, managing director of a $1.2 billion fund of hedge funds at New York–based family office Invus Financial Advisors, says she discovered in 2003 that Durus Capital Management, in which Invus had invested, did not have the diversified portfolio its owner had claimed. Lake says that Durus, a $600 million biotechnology and health care long-short fund based in South Norwalk, Connecticut, had at the time taken outsize positions in two publicly held companies, Aksys and Esperion Therapeutics. The three directors of the fund, who were supplied by Cayman-based International Fund Services, a provider of administrative services that was later acquired by State Street Corp., had requested position details from the manager but had not insisted on the information.
After hiring a legal team that included leading hedge fund law firm Schulte Roth & Zabel, Lake and two other investors staged a successful coup against Scott Sacane, the founder and manager of Durus, ousting the Cayman-based board and taking over the three board seats.
“It was a full-time job, and it was really hard,” Lake says of the role of director. She adds that she nonetheless drew satisfaction and saw justice served when Sacane received a three-year federal prison term in 2007 after pleading guilty to violating the Investment Advisers Act. His fund was liquidated, and Invus recovered its assets.
The kind of fund oversight and activism that Lake stepped in to do isn’t usually what investors sign up for when they invest in a hedge fund. But if a board isn’t doing its job, she says, somebody else has to: “I’m just surprised, based on everything that’s happened in the past year, that more investors aren’t asking for independent boards.”
