Now you see them – now you don't
Company Law 101 – if you attended the class and were awake in it, would teach you that the classic concept of management of a company is that the directors of a company are responsible for its management. This concept is important in regard to such legal issues as who owes fiduciary duties to shareholders and, in the case of insolvent companies or those teetering on the brink of insolvency, creditors, as well as some constitutional and regulatory matters. You may also have learnt that the Directors are officers of the company along with such people as the Secretary, Treasurer and others elected to positions of responsibility at the Annual General Meeting.
It may, therefore, come as a bit of a surprise to learn that such service providers to a company such as auditors and investment managers may also be either officers, or management, of a company. The auditor or investment manager may even be surprised to learn they are an officer, or part of management, of the company and, in some cases, may be dismayed by the legal consequences of such a designation for which they may not be insured.
In the Cayman Islands Grand Court the decision in the liquidation of Beacon Hill Master Ltd. ("BHM") (and its Cayman feeder fund) in regard to an appeal of the rejection of a proof of debt submitted by the auditor Ernst & Young Cayman Islands ("EYCI") established that the auditors were, in that case, officers of the company.
The Liquidators, and some feeder fund investors, of BHM had alleged that EYCI had failed to detect that the investment manager of BHM had produced false values for the assets of BHM and were liable for the loss suffered by BHM as a result of that failure. EYCI claimed to be a creditor of BHM for all costs and liability arising out of the Liquidators' and investors 'proceedings against it by virtue of the existence in their favour of indemnities from BHM (and the feeder funds).
In the course of examining whether EYCI had an indemnity from BHM, pursuant to the terms of the Articles of Association, the Grand Court of the Cayman Islands had to decide if EYCI was an officer of the company. The Grand Court referred to the case of Mutual Reinsurance Co Ltd. vs Peat Marwick Michell & Co (a firm) and another  1 BCLC 1 which found that under English Law (which is of persuasive authority in the Cayman Islands) auditors were officers of a company. The Grand Court was further supported in its conclusion by the provision in the BHM Articles which provided that the auditors should be appointed as officers at the Annual General Meeting.
The intended consequence of the decision was that EYCI had the benefit of the indemnity in the Articles of BHM in favour of officers of the company which covered all liability, except fraud, dishonesty and wilful acts or default.
The unintended consequence of the decision is that EYCI as an officer of the company owed fiduciary duties to the shareholders, but any liability to the company or shareholders for a negligent or improperly conducted audit would be indemnified.
It is desirable, generally, to have the company auditor as an officer of the company so the auditor owes fiduciary duties. However, it must be clearly thought through whether indemnities in the Articles in favour of directors and officers should extend to auditors.
In the same case the Grand Court decided that the investment manager of BHM was part of "management of the company" despite the fact the investment management contract described the investment manager as an independent contractor and the Articles of BHM specified the investment management activities to be subject to the supervision of the directors. The Grand Court decided that in the case of a hedge fund, such as BHM, the activities carried out by the investment manager were so fundamental to the purpose of BHM, and the directors actual activity by way of supervision relatively insignificant, that the investment manager was management of BHM.
In the case of BHM, this was significant to a contractual indemnity contained in the EYCI engagement letter covering losses attributable to "fraud of management". The Liquidators had asserted there had been fraud by the investment manager so the Grand Court held that the EYCI engagement letter indemnity applied.
It is, of course, standard in hedge fund documents sent to investors to point out the inherent conflict an investment manager has given that the fees it receives are based on asset value. Emphasis is placed on the existence of independent directors' management of the fund and auditors involvement in scrutinising the investment manger's numbers as a check on this conflict. However, the designation of the investment manager as "management of the company" undermines the system of checks and balances.
There is also a downside for the investment manager as soon to be introduced provisions of the Cayman Islands Companies Law introduce the concept of a Shadow Director which is "in relation to a company any person in accordance with whose directions or instructions the directors of the company are accustomed to act". Shadow Directors will be considered to have the same fiduciary and regulatory duties as duly elected and appointed directors.
It is by no means inevitable that auditors will be covered by indemnities applicable to directors and officers or when there exists fraud of the investment manager. Carefully drafted Articles and contractual indemnities can avoid such a situation and avoid unintended consequences which have a strong possibility of adverse effects on all concerned.
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.