The collapse of the billion-dollar Carlyle Capital Corporation Guernsey-based fund in 2008 led to litigation spanning a decade. The lessons to be learnt from this case and the legal analysis of directors' duties are relevant in the current climate of the covid-19 pandemic, which has caused severe global economic disruption and may lead to other fund collapses.
The Carlyle case arose from the collapse in March 2008 of a Guernsey fund, Carlyle Capital Corporation Ltd (CCC), which led to the loss of all of its $1 billion of capital. CCC was set up as a Guernsey company in 2006 and invested mainly in residential mortgage-backed securities (RMBS) issued by US government-sponsored entities Fannie Mae(1) and Freddie Mac.(2) The case went to trial, and was appealed and heard by the Guernsey Court of Appeal.(3) It was further appealed to the Judicial Committee of the Privy Council and settled a few months before it was due to be heard in October 2020.(4) The trial judgment, which runs to 525 pages, covered in detail the duties of directors, which is of significance to all jurisdictions that hold directors to similar standards, especially during times of crisis.(5)
In July 2010, CCC and its liquidators issued claims against the former executive and independent directors of CCC, the investment manager,(6) the promoter of CCC and a holding company (Carlyle) within the Carlyle Group structure for damages of no less than $1 billion, which rose to nearly $2 billion (including interest) by the close of trial.
CCC's business model was to make profits and eventually pay dividends mainly from the difference between the coupon it earned from its RMBS (that were guaranteed to pay full value at maturity) and the cost of financing those assets. The RMBS assets were financed using short-term one-month secured borrowing from US banks (called repo financing).(7) The RMBS were subject to daily margin calls if prices changed. CCC's investment guidelines stated that CCC should try to keep a 20% liquidity cushion in cash or equivalent to meet foreseeable margin calls.(8)
By 11 July 2007, the company had raised $945 million in capital and leveraged its capital 30 times to acquire an RMBS portfolio of over $20 billion.(9) It also held a small portfolio of non-RMBS assets.(10) The extensive risks the fund would take with its business model were clearly disclosed in its offering memorandum, including the risks associated with operating with high leverage.
In August 2007, market volatility increased dramatically, resulting in the market price of the CCC's assets being reduced significantly. This led its repo lenders to make large margin calls and, in an unprecedented manner, some of them also increased the haircuts on the amounts borrowed.(11)
CCC used virtually all of its liquidity cushion to pay the margin calls, managed to obtain and use a $100 million loan from Carlyle and sold its non-RMBS assets to bolster its liquidity and meet its higher borrowing costs.
Following the crisis in August 2007, CCC adopted a conservative strategy of negotiating the best funding terms it could, holding onto its assets, freezing asset purchases and allowing its portfolio to deleverage gradually. This was referred to at trial as CCC's capital preservation strategy.
By mid-February 2008, CCC's liquidity cushion had recovered to nearly 20%.(12) However, in March 2008, an unexpected and unforeseen liquidity crisis hit the financial markets, worse than the August 2007 crisis. A consequence of this crisis was a sharp contraction in the availability of repo financing. CCC's repo lenders marked the value of its RMBS down substantially, and as a result made extremely large margin calls, which CCC was unable to meet. It was put into liquidation by the Royal Court of Guernsey on 17 March 2008.
In the proceedings that were commenced in Guernsey, New York, Delaware and Washington DC, the plaintiffs alleged numerous breaches of duty, which were mainly focused on the defendants' alleged fundamental failure to take steps to reduce CCC's leverage and increase liquidity from July 2007. They claimed that this could have been achieved by selling a substantial amount of its RMBS assets, raising more capital or conducting an orderly winding down of CCC.
CCC had executive and independent directors.(13) CCC's constitution specifically required the appointment of three independent directors (IDs), who were not affiliated with the Carlyle group.(14) Their roles included providing oversight of decisions and proposals by the investment committee and CCC's management. The IDs had voting rights and sat on the audit committee. However, certain decisions required the approval of a majority of IDs, such as changes to investment guidelines.
Directors' duties in Guernsey law are in substance very similar to those under the English Companies Act 2006 and to director's duties before that Act under English common law. The plaintiffs' allegations of breach of duty can be broadly categorised into breaches of:
- fiduciary duties;
- the duty of skill and care; and
- statutory duties.
These will each be discussed in the upcoming updates.
For further information on this topic please contact Bryan De Verneuil-Smith or Simon Davies at Ogier by telephone (+44 1481 721672) or email ([email protected] or [email protected]). The Ogier website can be accessed at www.ogier.com.
(1) The Federal National Mortgage Association.
(2) The Federal Home Loan Mortgage Corporation.
(3) Carlyle Capital Corporation Limited (In Liquidation) v Conway  GRC014 CA.
(4) Carlyle Capital Corporation (in Liquidation) v Conway JCPC/2019/0083.
(5) Carlyle Capital Corporation Limited (in Liquidation) v Conway (Guernsey judgment 38/2017).
(6) Carlyle Investment Management LLC (CIM).
(7) A repurchase agreement (a repo) is a financial transaction in which one party (the borrower) sells an asset to another party (the lender) with a promise to repurchase the asset at a pre-specified later date. It is a form of secured borrowing. CCC's business model was predicated on a 2% "haircut" being applied to its repo borrowings by its repo lenders – ie, that CCC could borrow 98% of the current value of its RMBS. The nature of repo financing is summarised in the appeal judgment, Carlyle  2 Lloyd's Rep 179 at .
(8) This percentage arose from stress-testing the business model against the conditions of the worst liquidity crisis in recent memory, the long-term capital management crisis (LTCM) of 1998. The stressed value at risk assessment indicated that a 16% cushion would have allowed CCC to have survived the conditions of the LTCM crisis to a 99% confidence level, assuming no corrective measures were taken to protect the portfolio for 20 days. A decision was taken to increase the cushion from 16% to the 20% level for an extra (25%) safety over and above what would have been needed to survive the LTCM crisis.
(9) The fact that the assets could be leveraged so highly was disclosed to investors in the offering memorandum. See – of the trial judgment.
(10) CCC held a much smaller portfolio of riskier but higher earning leveraged finance and credit assets which were sold in August 2007 to raise liquidity without crystallising any significant losses.
(11) They were willing to loan to CCC a smaller percentage of the market value of the RMBS it held.
(12) At  of the trial judgment.
(13) There were four executive directors: two voting, two non-voting. The plaintiffs also claimed that CIM, TCG and Holdings were, by virtue of their power and influence over CCC, either shadow directors or de facto directors and therefore owed to CCC the same duties as de jure directors.
(14) Two of the IDs had banking and finance experience. The third was a Guernsey-based trust administrator.
An earlier version of this article was first published by Sweet & Maxwell.