In this fifth article in the KB Associates’ series on investment fund governance we examine two specific topics which fund directors regularly encounter, namely conflicts of interest and valuation issues.
Conflicts of interest
A conflict of interest creates a risk that professional judgment or actions regarding a primary interest will be unduly influenced by a secondary interest. A conflict of interest for a fund director can be defined as a situation where the duties and obligations placed on that individual in performing the role of a director may be impacted by a separate interest. An example is where a fund director provides consultancy services to other funds. A truly independent director is one who is independent of management and free from any business or other relationships which could significantly interfere with the director’s ability to act with a view to the best interests of the company.
Various fund governance codes require the board of an investment fund to consider potential conflicts of interest. Best practice requires funds establish clear procedures to identify and appropriately resolve conflicts of interest that may arise. Each director must disclose his interests to the board on appointment and each director should be required to make appropriate on-going disclosures to the board regarding entities in which he has an interest.
Where a particular conflict does arise, a director must be required to disclose such conflict to the board before the matter is considered. A common conflict is where a director has an interest in a contract under consideration by the board. In such circumstances it is appropriate for the director to abstain from the board’s vote, and indeed any consideration of the issues, in relation to that particular matter.
Independent directors may act for several funds managed by the same investment manager and they will receive director’s fees from each fund. Typically, the fees payable to a director will be agreed by the investment manager and this itself creates a conflict. A director’s primary commitment is the fund and not the manager and the director must not be influenced by the investment manager as highlighted by recent cases such as Weavering in the Cayman Islands.
A conflict may arise when an independent director serves on the boards of several funds established by different fund management groups. Many boards require that directors pre-clear any new director mandates the individual wishes to accept. A directors’ service agreement or letter of appointment will usually contain provisions dealing with issues such as confidentiality and indeed conflicts of interest. Directors need to be mindful that information acquired in relation to a specific appointment may be confidential and must not be disclosed to third parties.
In addition to conflicts of interest for individual directors, conflicts also arise at the service providers to the fund. An investment fund will usually delegate investment management to an investment manager who may provide investment services to a number of different funds. Conflicts of interest may arise and procedures must be designed to ensure that the persons involved in different business activities at the investment manager act in a manner which is fair to the investors in the fund.
Policies and procedures will need to be established which cover situations including personal account dealing, directors’ own investment in funds, aggregate orders and favourable investor terms.
- Some staff at the investment manager will have detailed knowledge about the fund’s investment composition and this information could be used for their own benefit. There needs to be a personal account dealing policy and a strict culture of confidentiality within the fund. A fund director may also be an investor in the fund and by virtue of their position on the board, they will have an informational advantage over other investors. Best practice dictates that directors should declare any personal holdings in funds for which they act, and they should also consider selling their holding to remove any conflict of interest. Indeed, many investors view directors’ investments in the fund as an automatic red flag item and as a result will not allocate to the fund.
- A conflict may exist where investment managers aggregate buy or sell orders and then allocate the block of securities across multiple funds. Investment managers need to have a clear and precise best execution policy to ensure each fund receives its correct allocation and that no fund is placed in a more advantageous position as a result of its allocation. Directors need to understand and review the execution and allocation process to prevent possible portfolio distortions.
- Directors will often have discretion to change subscription or redemption notice periods, minimum subscription amounts or impose or withdraw gates. Directors need to follow clearly defined policies that will not place the interests of certain investors over others.
- Other conflicts can arise in the area of suspension of net asset value, the use of side letters or the creation of side pockets for hard to value or illiquid assets. Conflicts of interest need to be identified and policies and procedures will need to be established to mitigate the risks.
There may also be conflicts of interest with the fund’s trustee/custodian. In regulated jurisdictions, the fund trustee is legally separated from the administrator but will often be part of the same corporate group. The trustee has a fiduciary obligation to protect the interests of investors in the fund but may also be in a position to impose charges on the fund. The fund directors need to identify these circumstances and implement policies which ensure that such conflicts are handled in an appropriate manner which is fair to investors.
It is the responsibility of the board of directors of an investment fund to devise, implement and then review the fund’s conflicts of interest policy. Such policy should identify circumstances which may give rise to a conflict which could damage the interests of the investment fund. The policy should also set out the procedures to be followed and the measures to be adopted to deal with such conflicts.
Valuation Issues
The board of directors has ultimate responsibility for fund valuation and it is essential that a fund has appropriate policies and procedures in place for the valuation of assets. Subscriptions and redemptions of fund shares/units must be at a price based on the net asset value and if the securities and assets of the fund are incorrectly valued investors may be treated unfairly.
Regulated funds are required to disclose to investors in the offering document the valuation methods to be used. The valuation policy should be customised to provide for the various types of assets which the fund will hold and the policy must be clear and unambiguous. Directors must look beyond what is in the prospectus and the regulator may also expect to see a fund specific valuation policy which is more detailed than the prospectus disclosure, but must be consistent with same.
Valuation for securities which are listed or traded on a regulated market should be relatively straightforward and may be the closing or last known market price. For securities which are unlisted or where a market value is unavailable, some administrators will provide in-house expertise to calculate “hard to value” securities, and in some cases this may be outsourced to specialist calculation agents or pricing vendors.
However, it may be the case that the investment manager to the fund is in the best position to value the securities and the board of directors may appoint a competent party within the investment manager to perform this function. A valuation committee will be established which may be chaired by an independent director but would also include a representative from the investment manager as well as individuals with experience in legal, compliance and risk management. The board of directors has a duty to ensure the investment manager has the appropriate skills to value these assets and they must determine the role, composition and operation of the valuation function and they will need to identify and prevent any conflicts relating to asset valuation. The investment manager should be in a minority position on the valuation committee in terms of voting rights.
There should be clear procedures documenting the situations where items must be brought to the attention of the valuation committee. The valuation committee in turn should report to the board. The valuation committee should meet as frequently as necessary to deal with valuation issues which arise and the minutes of the valuation committee should be available for review. If possible, the prices produced by valuation committee should be independently verified and reviewed before publication of the net asset value.
The fees received by the investment manager are normally based on a percentage of the fund’s total assets and the value assigned to specific assets impacts the performance fee to which an investment manager is entitled. Thus, there is a clear conflict as the investment manager stands to gain from an inflated valuation. The investment manager may also expose the fund to increased risks in an attempt to boost performance returns.
Directors need to be aware of these issues and there needs to be regular oversight by the board to ensure that the interests of the manager and the investors are aligned and the fund is not being exposed to undue investment risk.
Recognising the importance of valuation issues the International Organisation of Securities Commissions (IOSCO) issued a report on the principles of the valuation of assets held by collective investment schemes in May 2013. This report highlights the fact that investment funds can now invest in many complex and hard to value assets, including some that simply did not exist previously.
Some of the key principles listed by IOSCO are:
- The fund should establish comprehensive documented policies and procedures to govern the valuation of assets held.
- The policies and procedures should identify the methodologies that will be used for valuing each type of asset.
- The assets should be consistently valued according to those policies and procedures.
The IOSCO principles reflect a common approach and are intended to be a practical guide for both regulators and industry practitioners.
Conclusion
The issues of conflicts of interest and valuation present challenges to the boards of investment funds. Some regulators require that there is an appropriate documented policy for dealing with conflicts of interest and directors must always be cognisant of their specific duties in this regard. Valuation is absolutely critical to the fair treatment of investors and valuation methods must be clearly disclosed. For complex funds which invest in assets which are difficult to value, a robust valuation policy is essential. Implementing appropriate and effective policies to deal with these types of issues is a fundamental part of the role of a fund director.
If you have any questions regarding this article or general fund governance queries please feel free to contact one of the KB Associates consultants