Are Directors Responsible for Valuation?
Risk Without Reward frequently focuses on the issue of security valuation within a hedge fund. One of the thorniest questions is, of course, who is actually responsible for valuation.
Many investors assume that, if an administrator has been appointed, then it is the administrator who will be responsible for pricing. As we have often noted, this is not true - today's administrators argue that they are a "verification" not "valuation" agent. Indeed, current "best practice" guidance for the administration industry makes this clear: as we noted in a recent post,
"It should be noted that while some HFAs [Hedge Fund Administrators] have people, teams and service models which are capable of, and expert in, the calculation of recommended prices for individual securities, many others are not. A hedge fund manager or investor should not automatically assume that the HFA offers this service, employs this expertise or takes this responsibility."
So if the admin is out of the question, we are left with the hedge fund manager and, if we are looking at an offshore fund, the Board of Directors. Many recent best practice documents (see Castle Hall's resources page), notably AIMA guidance and the IOSCO paper on hedge fund valuation, identify the Directors, as the "Governing Body" of the fund, to be the entity with ultimate responsibility for valuation. Indeed, the Hedge Fund Standards Board guidance asks the hedge fund manager to "do what it reasonably can to enable and encourage the fund Governing Body" nearly 50 times: seems pretty clear that it's not the UK domiciled hedge fund manager driving the bus (now, that wouldn't have anything to do with UK tax rules, would it??)
It is against this background that we have been very interested to read a couple of recent hedge fund offering documents. Both used directors provided by one of the usual suspect group of Cayman law firms who, in these instances, were also the offshore counsel for the funds in question. In both cases, the offering documents contained a specific disclosure stating that the Directors were not responsible for:
- the commercial structuring of the fund (fair enough - even though the same law firm was very responsible for the commercial structuring of the fund)
- the purchase and sale of any investment on behalf of the fund
- the valuation of assets of the fund
- any loss or damage, unless such loss or damage is caused by the fraud or wilful default of the Directors (we note that this clause specifically does not hold the directors to a gross negligence standard, but we guess that's a topic for another day)
Where, then, does this leave investors? On one level, it is hardly surprising that the Directors of a Caymanian hedge fund are now saying that they are not responsible for the valuation of the fund's assets: after all, if you serve on several hundred boards, it's pretty difficult to keep track of current valuation issues on fund 132.
On the other, this explicit attempt to disclaim any responsibility for valuation is new. In our view, this illustrates, clearly and specifically, that the directors of an offshore hedge fund cannot be expected to provide anything more than a basic, corporate governance service designed to meet local filing requirements and comply with local business law. There is, it is clear, no attempt to provide any form of meaningful, active corporate governance.
As always, caveat emptor.
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