Court sends clear messages to delinquent hedge fund directors

In what may be the highest damages award ever issued in misfeasance proceedings against delinquent directors, a recent case in the Grand Court of the Cayman Islands sent a clear message regarding the performance of the supervisory role by hedge fund directors. The decision also provides guidance on the policies and good governance procedures that directors should consider adopting in order to meet his/her expected duty of skill, care and diligence. 

In the case of Weavering Macro Fixed Income Fund Limited (In Liquidation) versus Stefan Peterson and Hans Ekstrom, the Court found the defendant directors, Stefan Peterson and Hans Ekstrom, each fully liable to Weavering Macro Fixed Income Fund Limited (In Liquidation) for US$111 million in damages for losses caused by the directors’ wilful neglect or default of their duties. 

The decision, which we understand is being appealed, reaffirms the legal framework within which directors of Cayman Islands hedge funds must operate. As a general matter, it does not impact the Cayman Islands’ hedge fund model. It must be viewed in light of its unique and specific facts and, in this context, the case is an example of the extent to which delinquent directors may be held to account for losses caused by their inactivity and failure to satisfy their high-level supervisory role. 

 

Background 

The directors were appointed prior to the launch of the fund in 2003 as “independent”, non-executive directors. The fund’s records indicated that, from its launch until its liquidation in March 2009, the directors did very little other than attend board meetings and, on occasion, carry out basic and perfunctory administrative tasks when requested to do so by the principal of the fund’s promoter/investment manager. The court determined that the directors failed to provide any objective oversight of delegate service providers or enquiry as to the fund’s operations and financial position. The result was that the fund was able to enter into transactions in breach of its investment restrictions and, most notably subsequent to the financial crisis in late-2008, allowed the promoter/investment manager to inflate the fund’s net asset value and give the impression that it was making a steady return, when in fact it was suffering substantial losses with significant exposure to a related entity counterparty. 

 

The court’s decision 

The court affirmed the general proposition that directors owe fiduciary duties to their companies to act bona fide in what they consider to be the best interests of the company, to exercise their powers for the purposes for which they are conferred and not to place themselves in a position where there is a conflict between their personal interests and their duty to the company. 

The court recognised that the overall management structure of the fund “may not appear to be materially different from countless other open-ended investment funds” and that the Cayman Islands investment funds industry operates on the basis that investment management, administration and accounting functions will be delegated to professional service providers. It recognised that independent non-executive directors will exercise a high-level supervisory role. 

The directors, however, in this particular case were determined to have both “consciously [chosen] not to perform their duties to the fund, or at least not in any meaningful way” during the life of the fund and “subordinated themselves” to the wishes of the principal of the Fund’s promoter/investment manager (with whom the Directors had close personal and family connections). The Court repeatedly drew negative inferences from the personal relationship among the directors and the principal as having been inextricably linked with the underlying rationale for their lack of oversight. 

As such, the directors failed to exercise independent judgment, reasonable care, skill and diligence and to act in the interests of the fund and were found to be guilty of wilful neglect or default, which was outside the scope of usual indemnification provisions afforded to them by the Fund. 

Regardless of the outcome of the appeal and investigations in other jurisdictions (some of which have been discontinued – including an investigation by the UK’s Serious Fraud Office), a number of important propositions can be distilled from this judgment, which is a unique case of directors failing to perform their supervisory duty. 

 

The law – wilful neglect or default 

It was accepted that the directors were entitled to rely upon an exculpatory provision contained in the fund’s articles of association to limit their liability except where such liability had arisen because of their “wilful neglect or default”. The court adopted the English case law formulation (Re City Equitable Fire Insurance [1925] Ch 407) in determining the issue of what is meant by “wilful neglect or default” which can be condensed into a two-limb test: 

(a) knowing and intentional breach of duty; or 

(b) acting recklessly, not caring whether or not the act or omission is a breach of duty. 

The directors were held to have knowingly and intentionally breached their duty in that “they did nothing” over a sustained period of time. 

The second limb of the test is potentially more subjective in nature and, arguably, requires an appreciation on the part of directors that their conduct might be a breach of duty and coupled with a conscious decision to carry on regardless of the consequences. The court determined that it did not need to resolve the scope of the second test in this case. 

In determining this matter, the court looked at different phases of the life of a Cayman Islands hedge fund which, in general, can be broken into two key distinct time periods (although the judge held that the directors’ conduct was particularly blameworthy in a third phase of extraordinary circumstances from October 2008 in light of the global financial crisis). 

 

Duties in connection with fund establishment 

One of the arguments pursued by the directors was that, at the beginning of the fund’s life, they were entitled to delegate their tasks of reviewing the articles of association and service providers’ contracts which created the management structure and identified the responsibilities of those involved, to suitable professional advisers (eg lawyers/auditors). 

The court rejected this argument. In the court’s view, independent directors “must be alive to the fact that, when negotiating the terms of their respective contracts, all the service providers are quite properly acting in their own commercial interests”. Therefore, it is the directors’ duty to undertake a verification exercise and review the various contracts and satisfy themselves that each one is appropriate and consistent with industry standards and that, taken together, they do create an overall structure, which will ensure a proper division of responsibility amongst the service providers. The directors were considered not to have made any attempt to understand exactly how each of the professional service providers intended to perform their respective duties. 

In addition, the court noted that directors have a duty to satisfy themselves that a registered fund’s offering document complies with the disclosure requirements set out in the Mutual Funds Law. Directors should go beyond a desktop review of each offering document to ensure that it is both accurate and complete. 

 

Duties in connection with ongoing fund operations 

The directors sought to rely on the fact that they held regular board meetings to argue that they had discharged their supervisory functions. This argument was rejected by the court after a critical analysis of the evidence. The court affirmed the proposition that the Directors had a duty to conduct their board meetings “in a businesslike manner” and had “a duty to arrange for minutes to be taken of the meeting which fairly and accurately record the matters which were considered and the decisions which were made”. They were, however, also under a duty to “exercise an independent judgment by conducting a review in an inquisitorial manner and making appropriate enquiries of those involved, in particular the administrator and auditor.” The absence of requests for management accounts contemporaneous with the determination of net asset values, the lack of direct reporting at board meetings from the fund’s service providers and the execution of what appeared to be pro forma board minutes reflecting the meetings held or purported to be held (and failing to note the detail of any discussion ensuing at such meetings) drew particular censure, as did a number of circumstances in which the directors appeared to sign documents upon request by the investment manager without applying their minds to the content. 

The court also considered that these duties became enhanced, and additional supervision, oversight and diligence was required, in extraordinary or unique circumstances such as those which arose subsequent to Lehman’s collapse in late-2008. The directors failed to take appropriate pro-active and meaningful steps at this time and significant losses resulted from October 2008 until the Fund was liquidated in March 2009, such losses being the basis for the damages ultimately awarded in favour of the fund. 

 

Final thoughts 

Although the case does not create new law, by noting what the directors of the fund did not do, it clarifies the court’s expectations as to the policies and good governance procedures that a hedge fund director should consider adopting in order to meet his/her expected duty of skill, care and diligence. 

This case should be viewed in light of its unique facts and the court’s decision reaffirms that it will not look to import liability where directors, acting in a bona fide manner, have made a business decision which they determine to be in the interests of a fund. Directors, however, must be able to demonstrate that they have acted in a bona fide manner in satisfying their duties, including acting independently of any conflicts they may have with respect to other service providers of the fund, making due enquiry with respect to reports and agreements and ensuring that there is appropriate evidential support (including fair and accurate minutes from board meetings) which support the decisions they have come to. In the absence of clear or undisputed evidence the court may consider directors’ standards of conduct over the term of their appointment as otherwise being indicative of such matters. 

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