The Grand Court of the Cayman Islands, in finding two directors of a failed investment fund liable in damages for the fund's losses caused by their breaches of duty, has examined the role and responsibilities of fund directors generally. While the judgment contains some interesting commentary on practices and procedures of directors, the ramifications for well-advised funds with competent and diligent directors will be limited. Nevertheless, all directors should revisit their practices to ensure that they remain consistent with key corporate governance principles.
The proceedings, captioned Weavering Macro Fixed Income Fund Limited (In Liquidation) v Peterson and Ekstrom, brought by the joint official liquidators of Weavering Macro Fixed Income Fund Limited, Mr. Ian Stokoe and Mr. David Walker of PWC Corporate Finance & Recovery (Cayman) Limited ("the Fund"), sought damages against the Fund's two directors for breach of duty, including fiduciary duty. Like many Cayman Islands investment funds, the Fund's constitutional documents afforded the directors an indemnity, which had the circular effect of an exculpation clause for claims brought by the Fund itself, save for losses arising out of the directors' own wilful neglect or default.
In finding that the directors' conduct fell well below that which was required of them, and that they were guilty of wilful neglect or default, the Court confirmed that, although much of the day to day business of a fund may be managed by the fund's service providers, directors must nonetheless take an active role in supervising the affairs of the fund, and its business; and that directors must apply their minds and independent judgment to the decisions they make, and to the documents which they are asked to sign by the fund's service providers.
The following high-level points may be made at the outset:
- The two directors of the Fund were family membersof the principal of the Fund’s investment manager who perpetrated the fraud. They were not professional or expert directors and the Court was led to consider that one of them was simply doing a favour for his brother by acting as a director of the Fund in name only. This is very different to the typical profile of the board of directors of the vast majority of Cayman funds.
- The directors in this case demonstrated such lack of engagement with the Fund’s business that the Court felt compelled to conclude that they consciously chose not to perform their duties to the Fund, or at least not in any meaningful way. They signed fictitious minutes of board meetings which never took place. They failed ever to question the auditors or administrators about the Fund’s portfolio or its financial reports. Again, the extremity of these inadequacies is so fact-specific that it is hard to draw parallels with the approach adopted by the great majority of directors of Cayman funds.
- The Court confirmed two well-established points that are fundamental to the role of directors of Cayman Islands investment funds:
- Directors of hedge funds owe the same duties as directors of any other corporate entity.
Investors, counterparties and even regulators can therefore continue to derive comfort from the extra layer of oversight that diligent independent directors provide; and
- Directors of hedge funds may delegate certain functions to contracted service providers, although the fundamental duties owed by a director remain undiminished and they retain a duty of supervision and control. The extent of the duty to supervise, and the question whether it has been discharged, will depend on the facts of each particular case.
The prevailing hedge fund model, whereby the directors delegate investment responsibility to an investment manager, and administrative responsibility to an administrator, is therefore fundamentally unaffected, although directors should make sure that they have in place robust, proactive procedures to fulfil their residual supervisory responsibility.
- While the judgment does not create any new directors’ duties, it does set out the Court’s expectations as to how directors should approach a number of their common functions so as to be able to demonstrate the skill, care and diligence expected of them. The judgment serves as a reminder that directors need to (i) perform their duties in an active, diligent, inquisitorial and professional fashion, applying their own independent judgment in a businesslike manner, and (ii) develop and implement appropriate procedures that enable them to carry out their functions (and to demonstrate that they have done so).
The Fund was established in 2003. Mr. Peterson and Mr. Ekstrom were the only two directors of the Fund during its life. Although purporting to be independent directors, Mr. Peterson was the younger brother of the Fund's founder, Mr. Magnus Peterson (who was the controlling mind of the Fund's investment manager); Mr. Ekstrom was their step father. The Fund's set-up was uncontroversial: it had delegated certain functions to its contracted service providers, in particular, administration functions to its administrator ("PNC") and investment management functions to its investment manager ("WCUK").
During its life, the Fund consistently reported steady returns by investing in derivative type transactions, in particular futures and options. The Fund’s reported Net Asset Value grew rapidly from US$ 37.9 million in April 2005 to US$ 742.7 million in October 2008. The reported position was, however, in stark contrast to reality; the Fund was for many years, and perhaps since inception, making huge losses on its trading activities, but those losses were masked by fictitious gains on a basket of interest rate swaps (the “Swaps"). The Swaps were with a related party, Weavering Capital Fund (“WCF”), which was controlled by Mr. Magnus Peterson. WCF was, at all material times, a shell company, with very few assets. Notwithstanding, the value attributed to the Swaps by the Fund grew from US$ 1.4 million in April 2005 to US$ 633.5 million in January 2009 which, at that time, represented about 118% of the Fund's NAV. It was the directors' case that they did not know that the counterparty was WCF, believing that the Swaps were traded with international financial institutions.
No monies were ever paid by WCF to the Fund under the Swaps, nor was WCF ever in a position to do so. Thus, although real trading losses were being sustained by the Fund, its gains on the Swaps, as recorded in the Fund's annual accounts, always remained unrealized. Thus the Fund, for the majority of its life, relied on new subscription monies to meet redemption requests from those investors who wished to leave the Fund. The Fund was able to operate in this way until late in 2008 when, in light of the collapse of Lehman Brothers and the crises which gripped the financial industry, an insurmountable level of redemption requests were made by investors. Not having sufficient cash to pay these requests, the Fund quickly found itself in liquidation.
The Directors' Role
Although both directors were professional individuals, with extensive experience in the financial industry, neither claimed to have any specific experience in the types of trades and investments in which the Fund was engaged.
Both left the day to day management of the Fund to the investment manager and, in particular, Mr. Magnus Peterson. While the Fund's books and records suggested that the directors held quarterly board meetings, they did not; minutes, prepared by Mr. Magnus Peterson, bearing the purported dates of meetings were simply signed by one of the directors. Where a board meeting did take place, the conduct of the meeting, as recorded in the minutes, took a standard form; the directors merely noting a number of matters and points; there was no questioning by them, or enquiry made into the performance of the Fund, or its business, and nor did the directors seek confirmation of the Fund's performance from its other service providers. Mr. Magnus Peterson was the only person present at board meetings, other than the two directors. When the directors were asked to sign documents, for example the Fund's annual accounts, side letters, waiver forms, and the like, the directors simply did that which was asked of them, usually by Mr. Magnus Peterson, without question. In essence, the directors were merely the puppets of Mr. Magnus Peterson, offering no independent oversight of the Fund's business, and never applying their own independent judgment, let alone in a businesslike manner.
The Court unequivocally found the directors guilty of wilful neglect or default. The Court started with the well known statement of Romer J in Re City Equitable Fire Insurance  Ch 407:-
"An act, or an omission to do an act, is wilful where the person of whom we are speaking knows what he is doing and intends to do what he is doing. But if that act of omission amounts to a breach of his duty, and therefore to negligence, is the person guilty of wilful negligence? In my opinion that question must be answered in the negative unless he knows that he is committing, and intends to commit, a breach of his duty or is recklessly careless in the sense of not caring whether his act or omission is or is not a breach of duty."
The test of wilful neglect or default thus has two limbs, namely (i) knowing and intentional breach of duty, or (ii) acting recklessly, not caring whether or not the act or omission is a breach of duty. It was the first limb which was material to this case.
The Court confirmed that the oft cited principles enunciated by Jonathan Parker J in Re Barings PLC  1 BCLC 433 as regards directors' duties form part of Cayman Islands law, in particular that:-
"(i) Directors have, both collectively and individually, a continuing duty to acquire and maintain a sufficient knowledge and understanding of the company's business to enable them to properly discharge their duties as directors.
(ii) Whilst directors are entitled (subject to the articles of association of the company) to delegate particular functions to those below them in the management chain, and to trust their competence and integrity to a reasonable extent, the exercise of the power of delegation does not absolve a director from the duty to supervise the discharge of the delegated functions.
(iii) No rule of universal application can be formulated as to the duty referred in (ii) above. The extent of the duty, and the question whether it has been discharged, must depend on the facts of each particular case, including the director's role in the management of the company."
Although the Court accepted that the Fund's constitutional documents provided the directors with the power to delegate certain functions to the Fund's service providers, the Court confirmed that such delegation does not absolve them from responsibility; i.e. the duty to supervise is not delegable. The Court noted:-
"In the context of open ended investment funds, investment management, administration and accounting functions are invariably delegated to contracted professional providers, but the exercise by the directors of their power of delegation in this way does not absolve them from the duty to supervise the delegated functions. This means that they must do more than 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 the ordinary course of business, in respect of all matters falling within the scope of their supervisory responsibilities."
Each director accepted that he had a duty to supervise, and a duty to exercise independent judgment, skill and diligence. The Court found that the directors completely ignored their duties, and made no serious attempt to perform them. The Court also found that their decision to do so was conscious; the directors' own evidence was that they knew, as directors, that they had a supervisory role with respect to the affairs of the Fund. Thus, as a matter of law, the Court found that their default, arising out of this conscious decision to ignore their duty, must be regarded as wilful. As such, the directors' conduct fell squarely within the first limb of Re City Equitable Fire Insurance, and thus outside the ambit of their indemnity. Clarifying the purpose of the indemnity itself, the Judge noted that the intended effect of an indemnity of this type was to protect directors who do their “incompetent best”. "Those who attempt to perform their duty, but fail as a result of their carelessness, no matter how gross, are relieved from liability. Those who have an appreciation of their duty, but make no attempt, or at least no serious attempt, to perform the duty are not relieved from liability." Judgment was accordingly given against each of the directors in the amount of US$111 million.
Although this is the first case in which directors of a failed Cayman Islands investment fund have been held liable for the fund's losses, the principles of law applicable to the decision are not new. Directors of Cayman Islands investment funds owe the same duties as directors of any other corporate entity; it matters not that the directors may have used their powers of delegation to delegate certain functions to contracted service providers, the fundamental duties owed by a director remain undiminished.
The decision does, however, give some guidance as to what, in practice, is required of directors of Cayman Islands investment funds, and the steps they ought to take to ensure that they are properly discharging their duties. Although not exhaustive, the following may be gleaned from the decision:-
- Directors are expected to act in a professional, businesslike manner.
- Directors are expected to satisfy themselves, on a continuing basis, that the investment manager's strategy is fairly described in the offering documents and that the investment manager is complying with the investment criteria and restrictions adopted by the fund.
- Directors are required to acquire a proper understanding of the financial results of the investment and trading activity.
- Directors must satisfy themselves that there is an appropriate division of function and responsibility between the investment manager and administrator, and must continually satisfy themselves that the various professional service providers are performing their functions in accordance with their contractual obligations.
- Directors must ensure that information contained in the fund's offering document is accurate and not misleading, and that the offering document complies with the requirements under the Mutual Funds Law that it describe the fund’s shares in all material respects and contain such information as is necessary to enable a prospective investor to make an informed decision as to whether or not to invest. One observation of interest in the judgment is that every offering document should be subject to a verifying exercise to establish that it is both accurate and complete. The Court noted that how, and by whom, this exercise is done will depend upon the circumstances in general and the content of the document in question but will normally need to involve more than a desktop review. At the very least, directors need to make enquiry of the lawyers who have coordinated the work so as to gain a proper understanding of what has been done.
- Directors must continually apply their minds, and own independent judgment, to the business and affairs of the fund.
- If required to sign financial statements, or provide confirmation letters to the fund's auditors, directors must exercise independent judgment by conducting a review in an inquisitorial manner and make appropriate enquiries of those involved, in particular the administrator and auditor. They are not entitled to assume the posture of automatons by signing whatever documents are put in front of them by the investment manager without making enquiry or applying their minds to the matter in issue, on the assumption that the other service providers have all performed theur respective roles and therefore do not need to be supervised in any way.
- Directors must satisfy themselves that the fund's structure is consistent with Cayman Islands industry standards, and that the terms of the contracts with the service providers are consistent with industry standard.
- Directors should make enquiry to ensure that they properly understand the nature and scope of the work which the service providers will provide, and the limitations to that work, and that the division of work is understood by all, and must ensure that the service providers understand the level of supervision which the directors will be providing. A desktop review of the contract documents is unlikely to be sufficient.
- Directors must satisfy themselves that the terms of the contracts with the fund's service providers are in the best interests of the fund, including the terms on which the fund agrees to indemnify its service providers. The directors cannot simply rely on the investment manager to negotiate these terms; the directors must exercise an independent judgment, not least because the investment manager has a vested interest in the terms of its agreement with the fund.
- Directors have a duty to satisfy themselves that the audit firm engaged by the investment manager, on behalf of the fund, is duly approved by CIMA, and that it has completed its due diligence requirements on the fund, and issued its letter of consent to act as auditor.
- An agenda ought to be prepared, and circulated, before each board meeting. The agenda should, at least from time to time, provide for representatives of the fund's service providers to be present at the board meeting, for example a fund's administrator, with a view to reviewing the fund's financial position, and to be actively questioned by the directors with respect to the performance of the fund.
- Directors must inform themselves about the fund's investment activities and have a proper understanding of its financial condition. Asking to see, and reviewing, management accounts (and applying their own minds to them), and talking directly with the fund's service providers, will no doubt assist in discharging this duty.
- Directors must conduct board meetings in a businesslike manner, and must arrange for minutes to be taken of their meetings which fairly and accurately record the matters which were considered and the decisions which were made. The discussion should be summarized, at least to the extent that it is necessary for the reader to understand the basis on which the decisions were made.
- Directors are expected to be able to read a balance sheet and have a basic understanding of the audit process.
- If directors accept responsibility for the fund's audited statements (for example, by signing representation letters), they must exercise an independent judgment in satisfying themselves that the financial statements do present fairly the fund's financial condition. For example, a director may question the fund's administrator, or investment manager, or seek written confirmations from them about the performance of the fund. They may query whether any audit issues were raised during the course of the audit process, and how they were resolved. They may also ask to be taken, page by page, through the financial statements, including any footnotes.
Although not exhaustive, the above list does demonstrate the ongoing active role which directors must take in the affairs and business of the fund during its life, notwithstanding the usual delegation of their functions to the investment manager and others. Directors must continually take active steps, and apply their own judgment, to satisfy themselves that the business of the fund is being undertaken properly.
There is no statutory codification of the duties of directors of a Cayman Islands company, which derive from case law, primarily English. The consideration by a Cayman Islands court of those duties in the particular context of investment funds, is therefore to be welcomed, and the application of the principles set out in the judgment will reinforce the important role performed by the directors of those funds.
However, as directors and their advisors consider the judgment, they may feel that the particular facts of this case have led the Court to expectations which are unduly prescriptive. The decision is likely to be appealed to the Cayman Islands Court of Appeal and, possibly, further appealed to the Privy Council in England (the ultimate court of appeal for the Cayman Islands), and it may be that one of those appeal courts will adopt a less rigid approach. For the time being, this judgment represents the only analysis by a Cayman Islands court of the duties of the directors of an investment fund, and those directors must closely bear it in mind in performing their functions as such.