Based on a “slam dunk” set of facts, the Cayman Islands Grand Court recently delivered a very strong message to directors of Cayman Islands companies – at your peril do you deliberately ignore your fundamental legal obligations.
And in this instance expensively to the tune of US$111 million and costs.
The case (Weavering Macro Fixed Income Fund Limited (the “Fund”) v Stefan Peterson and Hans Ekstrom, Cause No. FSD 113 of 2010) involved an open ended corporate fund established in Cayman in 2003.
Third party service providers were appointed to carry out the usual functions required by the Fund, ie investment advisor/manager, administrator, custodian and auditor. The Fund was registered with the Cayman Islands Monetary Authority (CIMA) and listed on the Irish Stock Exchange.
The Irish listing requirement of two independent directors was met in a rather unusual way. The two directors, resident in Sweden (there were no Cayman-based directors), are the younger brother (Stefan Peterson) and elder stepfather (Hans Ekstrom) of Magnus Peterson, the real brains behind the Fund and the effective owner and controller of the UK investment advisor/manager, Weavering Capital (UK) Ltd. (red flag number one for investors).
Equally unusual was that both directors agreed to serve for no remuneration (red flag number two for investors).
Right out of the starting gate, the Fund was weak on substantive governance in terms of its board of directors; indeed a recipe for malfeasance, as proved to be the case (some potential Swedish institutional investors noticed this and did not invest; but a surprising number were not so wise). And something in excess of US$500 million went missing in what has been described as “Sweden’s mini-Madoff”).
Over the Fund’s life, the size and number of interest rate swaps (IRS) increased and by the second half of 2008 comprised the bulk of the fund’s assets (in clear breach of the investment restrictions). And these ultimately fictitious and overvalued IRS (that in turn produced an inflated NAV) were predominantly with a single counterparty – a BVI shell company controlled by Magnus Peterson, of which Hans Ekstrom was a director and Stefan Peterson had previously been a director.
The pack of cards came rapidly tumbling down after the Lehman’s bankruptcy filing in September 2008, with the fund receiving multiple redemption notices from rightly worried investors. The fund was placed in liquidation in early 2009. In due course, the liquidators sued the two directors for the amount of overvalued/inflated and irrecoverable redemptions (US$111 million) made by the fund towards the end of 2008.
The court’s decision
The court found that the directors should have realised that the fund was in serious trouble at the latest by November 2008 when they received the third quarter 2008 statements. They should then have taken appropriate action to stop all trading and all redemptions and to place the fund in liquidation (thus ensuring equal treatment for all creditors and investors).
In an expansive judgment, the Grand Court set out the well known common law duties of directors of Cayman Islands companies (citing leading English cases) and focused on the breaches of duties to exercise independent judgment, to exercise reasonable care, skill and diligence and to act bona fide in the best interests of the company, as pleaded by the liquidators.
The court concluded that the defendants were guilty of wilful neglect or default because they did not even try to perform their duties; rather they consciously chose not to perform their duties to the fund, even though they understood and accepted that they had a high level supervisory duty as the directors. And, most importantly, the standard exculpation and indemnification provision in the fund’s articles of association did not protect these directors, since the provision expressly excluded protection for conduct that amounted to wilful neglect or default.
The judgment details a litany of failures by the directors from the very inception of the fund. That they were supposed to be independent and non executive is irrelevant to the decision of the Grand Court. There is no definition of an independent or non executive director under Cayman law. Equally irrelevant is that they were not based in Cayman. A director is a director, period.
The facts will resonate with offshore practitioners as an only too familiar story of the traditional behaviour of many (but certainly not all) directors of offshore companies, eg, accepting without question the structure as presented to them by the promoter, conducting entirely pro forma or informal board meetings, signing phony or pre-prepared minutes, not reading or understanding documents or financial statements, signing whatever is put in front of them, failing to notice red flags, not asking any pertinent questions and generally remaining passive.
On the other hand, the judgment also supports the validity of the typical Cayman fund structure and, by implication, the correctness of the policies and procedures of the many highly competent, experienced and well respected independent directors in Cayman and elsewhere, on which the fund industry so depends.
The court validates the typical Cayman fund structure
The court found that it was entirely proper for a Cayman corporate fund (if so permitted by the articles of association) to have a non executive board and to delegate considerable functions to third party service providers, eg, an investment advisor/manager, administrator, custodian and auditor.
And, typically, it is the directors of a fund who approve these delegations at inception of the fund. But, and this is the crux of the matter, there must be both substance and form, although curiously the Court never used these precise and well accepted terms.
The directors cannot either simply approve the appointments and the documents presented to them by the promoters and the promoters’ legal counsel or thereafter sit back and let the fund run on autopilot, relying on the third parties nominated by the promoter to perform properly and without oversight or question, ie, in short, directors must “trust but verify”.
It is essential that, at the outset, the directors understand the fund structure and the third party agreements, satisfy themselves proactively that the structure, delegation, checks and balances, fees etc are proper and within industry standards.
Thereafter, they must keep themselves appraised and informed of the fund’s activities and properly supervise the discharge by the third parties of the functions delegated to them and, if necessary, appoint new or additional third party service providers and by implication get stuck in, not walk away, when the going gets rough.
New agreements, such as investor side letters, a subject all on their own the court admitted, should be subject to similar scrutiny.
The court also made the point that the directors may well not have all the skill sets (but if they do, they must use them!) to fully understand all aspects of the fund’s activities, particularly the investments and financial statements. The court did not in this case have to address the issue whether a fund and its board can delegate all financial statement preparation and related matters to a third party, as the directors had signed the financial statements.
But that does not relieve them of the obligation to apply their minds and make reasonable enquiries about these matters and, by implication, the obligation if necessary, at the expense of the fund, to hire outside experts who can advise and assist the directors in discharging their duties.
Case is not over
The decision has been appealed. The case also raises some issues that may trigger curiosity and speculation. First, why did the two defendants not join Magnus Peterson the principal bad apple behind the whole scheme and a poster child shadow director, who is being sued separately in England by the liquidators of the UK investment manager*, and maybe even the administrator, as a co-defendant?
Second, why were the US$111 million redemptions made in late 2008 stated by the liquidators (and accepted by the Court) to be “irrecoverable”; are there not claw-back possibilities that would significantly reduce the amount of the claim against the two directors?
Third, the court gave a judgment against “each of the defendants” for US$111 million (plus costs), ie on the face of it a total of US$222 million. It is assumed that the judgment is in fact joint and several for US$111 million, with the liquidators being entitled to go after either or both of the defendants for the full amount, with the right of contribution between the two defendants.
Fourth, was there any directors’ indemnity insurance or other back up third party indemnity, and would these respond in the case of wilful neglect and default and in what amount (valid insurance cover to the tune of US$111 million seems unlikely)? Fifth, enforcement and satisfaction may be a challenge as the defendants are based in Sweden and are unlikely to have the necessary personal assets to pay the full award; so are the defendants likely to face personal bankruptcy?
Lastly, how quickly will CIMA move to declare the two defendants not fit and proper to serve as directors of Cayman funds?
The lessons to be learnt
This case is a classic example of ‘no good deed goes unpunished”. Doing a favour for a close family member has proved this adage in spades. But, more importantly, the case gives a very clear road map to those who serve or would serve as directors of any Cayman company, not just hedge funds.
Many should sensibly pass by on the other side and leave the business to those with the necessary expertise and risk management tools. Ancillary outcomes will likely be that those remaining in the business will become more cautious, more proactive and devote more time and acuity to their duties and functions. This will likely also increase fees. Similarly, the cost of directors’ indemnity insurance may go up and the amount and terms of cover may become (even) more restrictive.
What may the future hold?
Liquidators and others in the plaintiff litigation business should not cheer too loudly. This is an extreme example that clearly falls outside the typical indemnification and exculpation provisions in Cayman company articles of association, usually the stumbling block to successful litigation against directors.
Directors who are merely negligent, or even perhaps grossly negligent, and attempt to do their “incompetent best” will still likely remain relatively unscathed, at least in Cayman, if not in the USA and elsewhere, unless and until Cayman Islands law is amended to outlaw such articles and contractual provisions that protect and indemnify directors against liability for (gross) negligence.
Prior to this case, there has been much discussion about the performance of directors of Cayman companies, both regulated and unregulated, and whether there is need for enhanced oversight of those who serve as directors and greater sanctions for those who fail to perform adequately.
The Cayman Islands Law Reform Commission is commencing a review of this entire area of the law and the Commission’s consultation papers and deliberations are awaited with great interest.
*: The UK Serious Fraud Office on 8 September 2011 confirmed it has discontinued its criminal investigation of Magnus Peterson and one other person, citing insufficient evidence for a prosecution.