August 3, 2010
Meridian Fund Advisers
Joyce E. Heinzerling, Principal
August 3, 2010
The Need for Corporate Governance Reforms or Established Corporate Governance Best Practices for Hedge Funds
There is a need for corporate governance reforms or established corporate governance best practices for hedge funds. My concern regarding corporate governance reforms for the hedge fund industry stems in large part from manager activity during the market dislocations in late 2008 and early 2009, and to a lesser extent from the litigation based on actions taken by hedge fund managers during that period. During this period, as the General Counsel of a fund of hedge funds, I witnessed U.S.-based managers aggressively attempting to take governance matters into their own hands without first consulting their boards. As well, for those managers advising hedge funds organized as limited partnerships (LPs) or limited liability companies (LLCs), the manager was, in a strictly legal sense, permitted to act alone as the general partner or the managing member in respect of governance matters. In the case of the LPs or the LLCs, there was a temptation on the part of managers during this period to often act first in their own best interest (for example, by attempting to trade out of a liquidity squeeze due to redemptions rather than prudently selling off assets to meet redemption requests).
Additionally, the continuous discovery of blatant frauds in the hedge fund sector has called into question the basic hedge fund model because of the lack of generally applied best practices for internal auditing and ongoing controls of operations, and, more importantly, external fiduciary controls. In the United States and abroad, institutional investors such as pension funds are increasingly insisting on corporate governance reforms as a pre-condition to investment, but these types of investor-led reforms most likely will affect only the very large multi-billion dollar funds into which the large, most assertive pension funds would invest. The January 2009 U.S-based Presidents Working Group Investors Committee Report (the IC Report) addresses hedge fund corporate governance, and clearly the expectations for governance in the IC Report apply to all hedge funds and not just those organized in corporate form. As the IC Report states, "regardless of legal form, hedge fund managers play a pivotal role in determining governance arrangements at the outset of a funds establishment and on an ongoing basis. While legal structures and relationships are important, investors should not focus on form over substance. Regardless of structure or domicile, investors should pay close attention to the governance mechanisms employed by a hedge fund manager and seek out managers that have established comprehensive approaches to address conflicts of interest and ensure investors interests are appropriately protected." (IC Report at p. 40). There is a mismatch, however, between the investor side of the industry and the manager side of the industry, as witnessed by the fact that the January 2009 U.S-based Presidents Working Group Asset Managers Committee Report (the AMC Report) does not address corporate governance structures or arrangements at hedge funds.
While the current form of hedge fund board oversight may provide some benefit to investors, I agree that the "level of investor protection provided by fund boards generally falls short of the protections provided by similar governing bodies, such as the boards of directors of U.S. public companies" (IC Report at p. 40), or the boards of SEC-registered investment companies such as mutual funds. Consequently, I believe that there is a real need for a Congressional proposal on hedge fund corporate governance reforms. Short of this, it would make sense for Congress to encourage the Presidents Working Group Asset Managers Committee to visit the Presidents Working Group Investors Committees concerns about hedge fund corporate governance and work together on the establishment of corporate governance best practices (Best Practices) for hedge fund managers. It can hardly be disputed that a managers adherence to Best Practices will benefit investors by helping to improve operational integrity through more consistent external controls. An additional advantage of adopting Best Practices would be that a Managers submission to the oversight of independent fiduciaries ultimately should function to strengthen a fund's intrinsic value. I have informally drafted my own set of general guidelines for hedge fund corporate governance best practices, and would be happy to share those general ideas with those persons who agree that legislative reforms or Best Practices are necessary.