Fund Governance

Fund corporate governance: the Woodford case study

Fund directors’ roles and responsibilities have come under scrutiny in the UK following the suspension of a fund run by the celebrated stockpicker Neil Woodford. What are the lessons from this affair for Luxembourg funds, and how might local and European regulators react?

According to the Financial Times of 27th July 2019, the Woodford affair indicates that the “role of the authorised corporate director is fraught with potential for conflicts of interest”. The headline screamed that this key aspect of the European regulatory landscape is “the flawed cog in the machine”. While this might be overly sensationalist, it does highlight a potential weak point in the corporate governance framework of the EU’s cross-border fund industry.

Potential for conflicts of interest

Since the 2001 Undertakings for Collective Investment in Transferable Securities (UCITS) directive, management companies (ManCos) have been at the centre of the fund management and distribution processes. They are the hub connecting the asset manager which takes the investment decisions, the clients and their advisors, the regulator, the service providers (depository, administrator, etc), and the auditor. They can do this cross-border thanks to their ability to use a pan-European “passport”. Ideally, the ManCo manages these relationships in an independent fashion, reporting breaches of corporate governance to the supervisory authorities.

However, rather than being a neutral player, the ManCo often depends on the asset manager. ManCos are frequently run in-house by the fund company, and it is common for the entire board of directors to feature employees of the asset management firm. Alternatively, the ManCo function can be outsourced to a third party. These normally handle business for several fund houses. But even this is no guarantee of independence. Directors can all still be employees of the asset manager, and even if there are independent people on the board, the ManCo is the fund’s client. Calling out potentially suspect behaviour could put a valuable commercial relationship at risk. This is the thrust of the accusations being levelled in the Woodford Equity Income Fund affair.

A questionable strategy

Australian firm Link Asset Services provides Woodford with management company services, amongst other services. Although it is a third party ManCo (known as an “authorised corporate director” in the UK), the British press has raised questions about whether Link focused too much on observing the letter rather than the spirit of the regulations. There is no suggestion of illegal behaviour, but there is the suspicion of a conflict of interest.

Neil Woodford made his reputation selecting high potential investments that tended not to be listed on stock exchanges. However, when his firm launched the Woodford Equity Income Fund he decided to use the UCITS regulatory structure. This despite these rules limiting the value of illiquid assets the fund could hold to 10%. The combination of the Woodford name and the highly respected UCITS structure encouraged substantial client interest, with the fund at one point totalling £10bn in assets.

Pushing the boundaries

After initial strong performances, the fund’s returns started to disappoint. To compensate, the fund invested in a series of illiquid, non-listed assets. However, the poor performance led to significant number of client redeeming their holdings, and this pushed the share of non-listed holdings above the 10% threshold. As the fund was unwilling to sell these holdings at a loss, they sought to finesse a solution by having some of these assets listed on the Guernsey stock exchange. More than just agreeing to this strategy, Link helped the fund organise these transactions.

Although this is a perfectly legal manoeuvre, it attracted criticism from investors and regulators. The rate of clients selling out of the fund increased until net assets shrank to a third of their peak. With the viability of the fund threatened, on 3rd June it was decided to suspend redemptions, a restriction that has recently been extended to December. The asset manager hopes to use this breathing space to avoid a panic sale as they work to offload some of the unlisted equity. In the meantime the UK regulator is investigating this case, a move which could lead to a wider reappraisal of rules.

Potential pitfalls in Luxembourg

What are the lessons for the Luxembourg fund industry from this episode? There were 429 ManCos operating in Luxembourg at the end of last year, say PwC. Industry players think that about half this number are third party operators, but with only a handful of large firms. This is an intensely competitive sector, where some of the more ambitious players might be tempted to cut corners on corporate governance in the pursuit of market share.

Regulator reacts

The local regulators are aware of the potential problems, and the CSSF issued circular 18/698 partly in response to concerns of this nature. This document spells out best practice for corporate governance in the fund sector: it seeks to ensure that directors have sufficient time and expertise to carry out their duties. Stress has been put on boards to “comply and explain”, with an insistence on effective reporting.

There is no legal requirement for funds to have independent directors, but informally, senior figures within the CSSF have suggested it would be preferable to have two on each board. This contrasts with the UK, which even prior to the Woodford affair, had decided to insist that all fund boards have two people without direct links to the asset manager. Although somewhat semi-detached from EU decision making at the moment, the UK fund industry remains influential and it is possible that this requirement could become generalised in Europe, either formally or informally.

Ultimately, though, third party ManCos with a long term growth strategy understand the importance of reputation. Allowing funds to bend the rules may have short term benefits, but with regulators and investors increasingly aware of the potential for conflicts of interest, this could be a risky option.