In a recent decision, the Commercial Court dismissed claims brought against five former directors of Madoff Securities International Limited for breach of directors’ duties relating to payments made to, or for the benefit of, Bernard Madoff, its major shareholder and CEO.  Now known to be the most spectacular fraudster of our times, Madoff was at the time of the transactions “a titan of Wall Street” in terms of wealth, reputation and respectability.

The essence of the claims was that the five had not complied with their statutory duties but had let Madoff do whatever he wanted without challenge. Despite its unusual facts, the case addresses questions that other directors may face in more everyday situations, such as:

  • How far am I allowed to trust in other directors’ competence?
  • Am I in breach of duty if I let the other directors overrule me? 
  • What if it turns out in hindsight that I was wrong?

Madoff’s London operation

Madoff Securities International Limited was based in London and authorised by the Financial Services Authority (which was the regulator at the time) to carry on investment business.  Bernard Madoff was its main shareholder and chief executive.

In June 2009 Madoff was sentenced in New York to 150 years in prison, and ordered to pay US$170 billion, in connection with his New York business. Madoff Securities International Limited had also collapsed, and its liquidators took proceedings against its former directors, claiming that payments to Madoff or at his direction were unlawful distributions, in breach of the rules on maintenance of capital. Millions of dollars had been paid in fees for research and other services said by the liquidators to be worthless; and lavish payments and gifts had been made to Madoff and his family. In addition, the directors had approved borrowings of millions of dollars from Madoff that bore interest and were said by the liquidators not to have been needed by the company.

A peculiar feature of the case is that all the payments made by the company were funded by Madoff or at his direction, so the commercial reality was that there was never any cost to the company. There was no secrecy about this, and at all times the company had appeared to the other directors, the auditors and the regulators to be solvent.  The liquidators’ case was therefore based very much on hindsight. None of the five other directors had had any reason to suspect that monies received from Madoff were the proceeds of fraud. The grounds were also rather technical, given that the company was never really using its own resources.

Directors’ duties

The main duties discussed in the case, and how they were applied to the facts, are outlined below. All of them, apart from the duty to exercise reasonable care, skill and diligence, are fiduciary duties, which means that a range of equitable remedies is available and that recovery does not depend on the company's being able to prove that it has suffered loss. As the Companies Act expressly provides, more than one of the duties can apply in any given case, and the judge’s analysis often repeats the same facts in relation to different duties.

Duty to promote the success of the company

This duty is set out in section 172 of the Companies Act and is sometimes referred to as the core fiduciary duty or the duty to act in the company’s bests interests. It requires a director to act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of the members as a collective body: not just the majority shareholders, or any particular shareholder or section of shareholders. In doing so the director must have regard (amongst other matters) to six specified factors (which include, for example, the likely consequences of any decision in the long term, and the desirability of the company maintaining a reputation for high standards of business conduct).

Were the five in breach by giving Madoff a free hand, or by letting him persuade them that he was promoting the success of the company?

The judge said:

  • part of the duty is to listen to the views of fellow directors and take account of them. Corporate management often requires the exercise of judgement on which opinions may legitimately differ, and requires some give and take. A director may legitimately defer to his fellow directors' views if he thinks they believe they are acting in the best interests of the company, even if he is not himself persuaded.
  • board decision-making is by majority. A director is not in breach of the duty merely because, if left to himself, he would do things differently. He doesn’t have to resign or refuse to implement the board’s decision.
  • even if the director fails to apply his mind to whether a transaction is in the interests of the company, it does not automatically follow that he is liable for the consequences of the transaction. The court will ask whether an honest and intelligent man in his position could, in all the circumstances, have reasonably believed that the transaction was for the benefit of the company.

Duty to exercise reasonable care, skill and diligence

To comply with this (non-fiduciary) duty, which is set out in section 174 of the Companies Act, the director’s performance must not fall below what a reasonably diligent and experienced person in the same role might reasonably have been expected to do in the same circumstances. But if he personally has additional skills, the standard is raised to reflect those skills.

The judge said that, although it is legitimate for there to be a division and delegation of responsibility for particular aspects of the management of a company, each director owes duties to the company to inform himself of the company's affairs and join with his fellow directors in supervising them. It is therefore a breach of duty for a director to allow himself to be dominated, bamboozled or manipulated by a dominant fellow director if that means he is totally abdicating his responsibility. If he knows his fellow director is misapplying company property and takes no steps to stop him the director is not just in breach of the duty of care, skill and diligence: he is party to the misapplication of property by having authorised or permitted it.

Applying this to the facts, however, the judge reiterated that a director is entitled to rely on the judgement, information and advice of a fellow director whose integrity, skill and competence he has no reason to suspect.   Where there is a director with a record and reputation for outstanding skill and experience in the business, the other directors are entitled to accord a high degree of deference and trust to his views as to what is in the company's best interests. It would be unfair and unrealistic to expect any of them to have done anything except attach great weight to Madoff's views.

Duty to exercise independent judgement

This duty, which is set out in section 173 of the Companies Act, requires a director’s judgement to be his own.  Directors may be in breach if they fail to take appropriate advice, but even where they take advice they must apply it according to their own judgement.

The judge said that to take the view that Madoff knew best was not a dereliction of the duty. It was a legitimate recognition that his high standing in the financial world reflected a level of skill and experience which equipped him to know what was best for the company, and put him in a much better position to make that judgement than any other director.

Duty to act within their powers

This duty, set out in section 171 of the Companies Act, contains a requirement for directors to use their powers for a proper purpose – which means for the purposes for which they were conferred by the company’s constitution. Using a power for a different purpose, even if there is nothing else unlawful about it, is a breach. The judge said that, although the duty often overlaps with the section 172 duty, the duties are distinct. Just because the directors believe in good faith that they are exercising a power in the company's best interests does not stop its being an improper use of the power.

Of course, using a power to do something inherently unlawful will always be an improper use of the power. Here the discussion centred on whether the various payments by the company were disguised unlawful distributions of capital to Madoff, and touched on a very important question for directors: am I liable to the company if it turns out in hindsight that I got the facts wrong and that I mistakenly authorised an unlawful dividend, or approved a transaction that was an unlawful distribution? A typical remedy would be to order a director to restore the payment to the company (although relief from sanction might be given if the director establishes that he acted honestly and reasonably).

The judge commented that the law was not clear on whether, in the case of a dividend payment – where even the most technical error makes the dividend unlawful, however well-intentioned the directors are – the directors must be held to account even if they had no intention of breaking the law. He did not have to decide the point, but said that, in his view, a director is only liable for improper exercise of the power to pay dividends if he knows that it is for an improper purpose or knows of the facts that make the purpose improper.

In the case of a transaction that purported not to be a distribution but might be characterised as one (as opposed to a dividend, which self-evidently is a distribution), the court must decide whether it was in substance what it in fact purported to be. To do that, the court should take account of the directors’ intentions and their perceptions and judgements as to what was going on. The transactions funded by Madoff were of this type. As such, they must be characterised by reference to the knowledge and intentions of the protagonists at the time. Deciding that the transactions were not distributions, the judge said:

  • in assessing the state of mind of the directors, and what they perceived to be in the interests of the company at the time, the court could not ignore the fact that, since Madoff always funded the payments, the directors had not been asked to make or sanction payments that were coming out of the company's own resources. Where there is an arrangement for subsequent reimbursement, rather than prior funding, the position might not always be so clear; if, for example, at the time the company was making a payment the directors had merely had a hope or expectation that the company would be reimbursed, a payment might have been an unlawful distribution.
  • the payments were made on Madoff's instructions and on his advice that they were of benefit. The payments were openly recorded and their accounting treatment was sanctioned by the auditors, who were fully aware of what was being paid for.
  • the payments were also in discharge of already-existing contractual obligations (none of the five having been involved in entering into the obligations).
  • although, to establish that a director was in breach of duty, it was not necessary to prove that the company had suffered loss, that did not mean the court must ignore any benefit received by the company from the very transaction which constituted the breach – and in fact there was no loss.

Shareholder approval

While there was no current or foreseeable doubt as to the solvency of the company, informal unanimous shareholder approval of the transactions (known as the Duomatic principle) would have sanctioned breaches by the five of the section 172 and section 174 duties.

The judge pointed out, however, that an unlawful distribution could not be blessed by the shareholders, as the shareholders in general meeting could not themselves lawfully do what they purported to approve the directors in doing. In fact, the judge said it would be the same with any other breach of the section 171 duty to exercise powers for a proper purpose – although we question whether this is the case where what is done is not otherwise unlawful.

While the judgment will be welcomed by directors, it came at a high price.  The liquidators instructed City lawyers and four barristers appeared at trial.  Four firms of solicitors were required to represent the defendants’ different interests.  The total legal bill will have been significant.  This is a reminder for directors to check the terms and scope of any indemnities provided by their companies for legal costs and also to check, proactively, the terms of any Directors’ and Officers’ insurance policy, which will typically be designed to provide cover for defence costs and/or judgments in situations such as this.

Madoff Securities International Limited (in liquidation) v Raven and others