The Financial Services Division of the Grand Court has just delivered what is already being hailed as a seminal judgment on the subject of directors' duties in the context of offshore hedge funds.
In Weavering Macro Fixed Income Fund Limited (In liquidation) v Peterson and Ekstrom, the Court found a fund's independent directors guilty of wilful default in the discharge of their duties, and ordered them to pay damages to the fund's liquidators in the sum of US$111 million, representing the losses suffered by the fund which were caused by their default.
It was a case of extreme facts: the fund's investment manager (Magnus Peterson) arranged the appointment of his younger brother and elderly stepfather to serve as the fund's directors on a gratuitous basis, merely to meet minimum legal requirements rather than to form a real board of directors. For the next 6 years, they did nothing to discharge their functions as directors beyond signing any number of documents at the manager's request, and even signed fictitious minutes of two board meetings which never took place. This semblance of corporate governance allowed the manager (while deceiving the directors and other service providers) to fraudulently inflate the fund's NAV by booking fictitious interest rate swap transactions to disguise substantial losses which the fund was suffering. By the time this scheme was discovered and the fund was put into insolvent liquidation, over $141 million had been wrongly paid out to investors by way of redemptions based on NAVs which were artificially inflated to the tune of $111 million in aggregate. In these circumstances, it was easy for the Court to find the directors guilty of wilful default – an essential finding, since it disqualified them from relying on an indemnity from the fund which would otherwise have blocked the liquidators' claim.
Directors' duties defined
These facts also made a convenient platform for the trial judge to make a series of stern statements of principle about the duties of hedge fund directors. These statements are important because the Court took long-standing principles concerning the duties of non-executive directors in a conventional company structure and adapted them for the unique structure of a hedge fund – with its array of professionals independently performing various critical functions in support of management
The key statements are as follows:
- The Cayman Islands investment fund industry works on the basis that investment management, administration and accounting functions will be delegated to professional service providers and a company's independent non-executive directors will exercise a "high level supervisory role". They must also make sure that the scope of their own supervisory role is clearly understood by all concerned.
- At the fund formation stage, directors must satisfy themselves that the offering document complies with Cayman Islands law; that the terms of the service providers' contracts are reasonable and consistent with industry standards; and that the overall structure of the fund will ensure a proper division of responsibility amongst the service providers. Directors must act in the best interests of the fund which, in this context, means its potential investors.
- Whilst independent directors rarely have the technical expertise and experience to be able to monitor sophisticated investment strategies and trading techniques in a direct hands-on manner, they are expected to satisfy themselves (on a continuing basis) that the fund is complying with investment restrictions set out in the offering documents and to acquire a proper understanding of the financial results of the investment and trading activity, without which they would not be in a position to perform an overall supervisory role.
- It is their duty to satisfy themselves that there is an appropriate division of function and responsibility between the investment manager and administrator. They need to satisfy themselves, on a continuing basis, that the various service providers are performing their functions in accordance with the terms of their respective contracts and that no managerial and/or administrative functions which ought to be performed are left undone.
- Independent directors must do more than simply react to whatever problems may be brought to their attention by the other professional service providers. They must apply their minds and exercise an independent judgment in respect of all matters falling within the scope of their supervisory responsibilities.
- Reviews of financial accounts must be conducted in an inquisitorial manner, the directors making appropriate enquiries of the administrator and auditor. The directors are not entitled to assume that the other service providers have all performed their respective roles (actual or perceived) and therefore do not need to be supervised in any way whatsoever.
- Independent directors are expected to be able to read a balance sheet and have a basic understanding of the audit process. If they accept a responsibility for a fund's financial statements (by issuing management representation letters and signing the financial statements), it is their duty to exercise an independent judgment in satisfying themselves that the financial statements do present fairly the fund's financial condition
Directors' reliance on indemnities
Where directors have the benefit of an indemnity for all loss causing conduct other than that constituting "wilful neglect or default" (the current industry standard), liability can only accrue where they know that they are committing, and intend to commit, a breach of duty; or are recklessly careless in the sense of not caring whether their act or omission is a breach of duty.
In this case, the Court held that directors who effectively do nothing for a period of years, while knowing they had a duty to supervise, will be found to have intentionally neglected their duties and thus liable; on the other hand, directors who make a serious attempt to perform their duty but fail as a result of carelessness or incompetence, no matter how gross, will be relieved from liability by virtue of the standard indemnity.
Given the extreme facts of the Weavering case, the Court did not have to decide the question whether appreciation by directors of a possible breach of duty coupled with a conscious decision to carry on regardless would satisfy the lesser test of "reckless indifference". In most cases, where the facts are not as stark, this will continue to be a fertile ground for debate.
Caveats, open issues and unanswered questions
This represents the first rather than the last word on hedge fund directors' duties. This judgment was delivered only on 26 August 2011. It may still be subject to appeal; and no other court has yet had an opportunity to comment on its findings or apply its statements of general principle.
There was no difficulty in applying those statements of principle in the Weavering case, because the directors in question "consciously chose not to perform their duties to the fund" while they also "knew perfectly well that their behaviour was wrong". In other cases, the question of what constitutes a "high level of supervision" will be subjected to more rigorous scrutiny.
In particular, the proper interaction between directors and other key service providers calls for closer review. At one point in the Weavering judgment, the Court did indicate that the directors were entitled to rely on the fund's administrator and auditor to use reasonable skill, care and professional judgment in (respectively) preparing financial statements and conducting audits of those statements. But it is not entirely clear what directors can safely rely on, if it is also "their duty to exercise an independent judgment in satisfying themselves that the financial statements do present fairly the fund's financial condition".
The judgment also stated, conversely to the proposition advanced above, that administrators and auditors "are entitled to rely upon the directors to perform their role". This begs a number of questions about the question of contribution and third party claims in situations where a number of actors are involved in the preparation, issue and approval of financial statements which turn out to be wrong.
These questions did not have to be addressed in the Weavering judgment, because there is no suggestion that the liquidators were also advancing claims against the administrator or and auditor; nor that the directors sought to join them in these proceedings. In future cases, clearer distinctions will need to be drawn between supervision of the process by which other service providers perform their functions and the content of what they produce as a result.
Finally, a word about the damages award: it was fixed by reference to the amount of irrecoverable redemption payments based on falsely inflated NAV calculations after the fund continued trading when the directors should have discovered the fraud and terminated its business. The judgment says nothing about why those redemption payments were irrecoverable, which is surprising when there are many cases ongoing (in Cayman and elsewhere) where 'clawback' claims are being made against investors who redeemed in similar circumstances
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.