Last month, the Cayman Islands Court of Appeal handed down its judgment in Weavering Macro Fixed Income Fund Limited (in Liquidation) (the "Fund") v Stefan Peterson and Hans Ekstrom (the "Directors"). The appeal from the first instance decision was allowed and the Grand Court's order of 26 August 2011 was set aside.
In summary, while the Court of Appeal agreed with the Grand Court that the Directors of the Fund had been negligent, the Court of Appeal held that the evidence did not support a finding of wilful neglect or default. The Directors were, therefore, able to rely upon the indemnity and exculpation provided to them in the Fund's articles of association.
The Fund collapsed in 2009 when it came to light that a high proportion of the assets (namely, a number of interest rate swaps with a related entity) on its balance sheet were fictitious. The Fund had been structured in the usual way, with responsibility for investment strategy and trading delegated to an investment manager and accounting functions delegated to a professional administrator. Unusually, though, the sole directors of the Fund were the brother and elderly father of the principal of the investment manager.
After its collapse, the Fund's Joint Official Liquidators (the "JOLs") brought claims against the Directors in the Cayman Islands. The central allegation was that the Directors had wilfully breached their duty to exercise reasonable skill and care by not properly supervising the performance of the Fund's service providers (particularly the adviser and investment manager). The JOLs' case was that, had the Directors performed their "high-level" supervisory duty to the requisite standard of skill and care, they would have discovered sooner that the counterparty to the interest rate swaps was a related entity and the Fund would not have continued to make redemption payments on the basis of grossly inflated Net Asset Values ("NAVs").
Grand Court Decision
At first instance, the Grand Court accepted the central allegation that the Directors had wilfully breached their duty to exercise reasonable skill and care. Although Jones J accepted that, as a result of the structure of the Fund, and the role of its other service providers, the Directors' supervisory role was a "high-level" one, he found that the Directors had wholly – and wilfully – failed to perform that role. Jones J found that the Directors ought to have discovered, by no later than early November 2008, that the counterparty to the interest rate swaps was a related entity. He found that the Directors' wilful neglect had caused the company to suffer losses of at least US$111 million (being the difference between what was actually paid out by the Fund and what would have been paid out on realistic NAVs) and he gave judgment against each of the Directors in that sum.
The Court of Appeal agreed with Jones J that the Directors had failed to perform, to the requisite standard, their "high-level" supervisory duty in relation to the performance by the Fund's service providers (particularly the adviser and investment manager). However, the Court of Appeal considered that the evidence which had been before the Grand Court did not allow Jones J to reach a finding that the Directors had known that they were breaching their duties – and that, the Court of Appeal held, was critical to a finding that their neglect or default was wilful. (See footnote 2 of Maples and Calder's August 2011 updateLandmark Decision of Cayman Islands Grand Court on Duties of Independent Non-Executive Directors of Investment Funds, which predicted that the inferences drawn by Jones J as to the Directors' intentions were ripe for appeal -http://www.maplesandcalder.com/news/article/landmark-decision-of-cayman-islands-grand-court-on-duties-of-independent-non-executive-directors-of-investment-funds-142).
The Court of Appeal confirmed that the correct test for wilful neglect or default was the classic formulation in Re City Equitable Fire Insurance(1925) that negligence is wilful if a person either: (i) knows he is committing and intends to commit a breach of duty; or (ii) is recklessly careless in that he does not care whether or not his act or omission is a breach of duty.
In the Grand Court's first instance judgment, Jones J found that the Directors fell within the first limb of this test for wilfulness; i.e., the Directors knew they were breaching their duties. The Court of Appeal did not agree that the evidence supported this finding. Both Directors had given evidence that they honestly believed they were complying with their duties and it was never put to them during cross-examination that they knowingly and intentionally breached their duties. Jones J did not give any reasons for disbelieving them. The Court of Appeal therefore considered that, while the Directors had plainly been negligent, there was no evidential support for Jones J's finding that the Directors knew that they were being negligent. As a result, they were entitled to rely upon the indemnities and exculpations in the Fund's articles of association. It is well established as a matter of Cayman Islands law that such indemnities and exculpations are effective, provided that directors may not be indemnified for fraud, wilful neglect or wilful default.
Although it was not the basis for Jones J's first instance judgment, the Court of Appeal also considered whether the second limb of wilful neglect or default applied, i.e., whether the Directors were reckless in that they did not care whether their acts or omissions were breaches of duty. The Court of Appeal agreed with the Directors' contention that, to establish recklessness and satisfy this second limb, it was necessary to establish that a director appreciated that his conductmight be a breach of duty and nevertheless continued with such conduct. For the same reason that the first limb was not established, i.e., the Directors' unchallenged evidence in this case was that they honestly believed they were complying with their duties, this second limb was also not established.
Essentially, the Court of Appeal did not disagree with the Grand Court in relation to the relevant legal principles governing directors' duties and wilful neglect or default: the difference between the Court of Appeal and the Grand Court was in relation to whether the evidence in this case supported a finding that the Directors knew that what they were doing was wrong.
Practical Guidance for Independent Non-Executive Fund Directors
The Grand Court's first instance judgment attracted considerable interest, not least because of Jones J's (obiter) comments as to the practical steps which independent non-executive directors of Cayman Islands funds should take in order to comply with their duties as directors (see Maples and Calder's August 2011 update on the first instance decision, referred to above).
On appeal, the Directors argued that Jones J had erred in identifying the scope of the Directors' duties on the basis of his own subjective expectations as to what fund directors should do, without reference to authority and on a "rigid and overly prescriptive basis". The Court of Appeal acknowledged that the Directors' submission could not be "dismissed as fanciful". However, given that the Court of Appeal agreed that the Directors had undoubtedly been negligent, and considering no serious criticism was made by the Court of Appeal of the substance of Jones J's obiter comments on what fund directors generally ought to do in order to discharge those duties, directors of Cayman Islands funds should continue to regard Jones J's dicta as useful guidance as to some of the steps which fund directors should take in order to discharge their supervisory duties.
Nevertheless, as explained in Maples and Calder's update on the first instance decision, there is no "one size fits all" answer as to what independent non-executive fund directors should do in any particular situation and whether a director has discharged his duties will always require a fact-sensitive approach. Accordingly, while Jones J's dictashould be treated as helpful, fund directors should be wary of treating it as a definitive or comprehensive list of steps which they must take: in many cases, to comply with their duties, a fund director will be required to take more or different steps than those suggested by Jones J.
Moreover, while the Court of Appeal's decision reinforces the robust nature of director indemnities, directors who are performing their duties on a day-to-day basis ought to be slow to take undue comfort from that. Directors who take actions (or who fail to take actions) in reliance upon their indemnification arrangements may be inviting a finding of wilful default.
It is important to note that the Court of Appeal has not lowered the standard of what is expected from Cayman Islands directors. The bar remains in the same place as it was before the Court of Appeal's decision. It is also worth remembering that the conduct of the directors complained of took place prior to the issuance of the Statement of Guidance for Regulated Mutual Funds ("SOG") issued by the Cayman Islands Monetary Authority on 13 January 2014 (see http://www.maplesandcalder.com/news/article/cima-turns-the-spotlight-on-corporate-governance-for-regulated-mutual-funds-672/) A number of principles in the SOG reflect some of the guidelines suggested by Jones J at first instance.
It is not yet known whether the JOLs will appeal the Court of Appeal's decision, but if there is a further appeal, it is possible that there may be further clarification provided by the Privy Council as to the scope of the duties owed by and indemnities provided to Cayman Islands fund directors.
Associate (Maples and Calder
+1 345 814 5318