On 26 August the Grand Court of the Cayman Islands delivered a judgment in the case of Weavering Macro Fixed Income Fund which found the directors of the fund guilty of wilful neglect or default and ordered them to pay US$111 million in damages. The reaction to the judgment has been varied ranging from calling the decision a warning for independent directors to it being a confirmation of current industry practices.
The directors in the case were found to be acting in breach of their duty to exercise independent judgment, failing to exercise reasonable care, skill and diligence and failing to act in the interest of the fund.
The Swedish directors Stefan Peterson and Hans Ekstrom were in fact related to the investment manager Magnus Peterson and did not receive any compensation for the exercise of their duties, which they performed as a favour to their stepson and brother.
The court heard that, although having the appropriate qualifications to act as directors to the fund, Peterson and Ekstrom “went through the motions of appearing to hold regular quarterly board meetings but, in reality, did nothing in that these meetings served no purpose other than recording of information that was in large part apparent from the monthly statements sent to investors”.
Despite being aware of their duty to supervise, the court said, the directors “did nothing, and carried on doing nothing for almost six years”. They had failed to discharge their duties by “signing whatever documents were put in front of them without reading them, or, if they did read them, without applying their minds to their content”.
The court concluded that, had the directors discharged their duties correctly, the fund’s precarious financial position and breach of its own investment criteria would have been identified by the board and the fund would have been put into liquidation at a much earlier stage. The court assessed the losses to investors as US$111 million and based the fine on this estimate.
The size of the penalty raised a few eyebrows, but more importantly the case has been considered important by observers because Justice Jones spelled out in plain English what a court expects from fund directors in terms of fund governance.
The judge pointed out that independent directors have to provide more than just an administrative service and react to problems that are brought to their attention. Instead they should “review in an inquisitorial manner and make appropriate enquiries of those involved” and seek information from all service providers involved in the fund. Directors are required to acquire a proper understanding of the fund’s financial results and ensure that the fund complies with the investment criteria and restrictions as set out in the fund’s constitutional documents.
All these activities have to be documented in minutes that make clear how decisions were taken and how the fund was supervised. In the Weavering case the judge concluded that there was no documentary evidence reflecting that the directors ever sought to discuss or enquire about any subject at all.
Reaction to the judgment in Cayman has been immediate, with fund directors seeing the judgment as a confirmation of their own business model and professionalism and others calling it just the opposite: a wake-up call for independent directors and their current business practices.
The Cayman Islands Directors Association condemned the behaviour of the independent directors, pointing out that it would have violated the association’s code of conduct, but the directors in questions were of course not Cayman-based and not members of CIDA.
Chris Johnson, of business recovery and insolvency firm Chris Johnson & Associates in turn said it “is a welcome decision and a wake-up call to those in the Cayman Islands that provide directors as a career.”
And former CIMA Chairman Tim Ridley said, “this has been a long time coming and should be a real and final wake up call to those few remaining people, and their insurers, who still think ‘just tell me where to sign’ is good enough.”
In an article for Cayman Financial Review Ridley noted the duality of the judgment, saying that on the one hand the verdict 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”, in terms of directors “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, he said, 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”.
Professional vs amateur
Don Seymour, managing director of DMS Management, argued in his commentary on the judgment that the Weavering case is a clear endorsement of the professional fund director model compared to the amateur model. “It is highly doubtful that this catastrophe could have occurred in a professional fund governance firm, with professional full-time directors having vast fund directorship experience, ably assisted by professionally qualified staff following established policies and procedures based on industry best practices,” Seymour wrote.
“The court decision reaffirmed what astute fund investors and sponsors already know – the professional fund governance model does far more work and is far more productive than the amateur model,” he said.
Seymour insists that directors need professionals to support them in the discharge of their duties, saying ”it is difficult to imagine any directors meeting the court’s expectations without employing a team of professionals with a broad range of deep hedge fund skills to assist the director in reviewing complex matters, researching issues and asking probing questions.”
Seymour argues that the court recognised the ability and necessity for directors to delegate to competent service providers within the hedge fund structure, “but also made very clear that such delegation does not absolve the directors of the duty to supervise such delegation, albeit at a high level”.
Ridley agrees that the court found that it was entirely proper for a Cayman corporate fund to have a non-executive board and to delegate considerable functions to third party service providers, such as the investment advisor/manager, administrator, custodian and auditor. But and this is crucial “they cannot 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”, he said.
“In short, directors must trust but verify,” Ridley wrote.
It will remain a matter of debate in the industry how many funds can be served by one director alone in light of the duties defined by the judgment.
“For those professionals providing directorships to hundreds of companies this is a warning that there may be more bad news to come,” warned Johnson.
Highwater partner Gary Linford agreed with the scope of responsibility outlined by Justice Jones and expressed a strong belief in a ‘limited capacity’ business model.
“Any director is physically constrained by his available time, no matter how experienced and dedicated his support staff, because the decision making responsibility is rightly the director’s alone and cannot be delegated,” Linford noted.
“It is therefore not surprising that fiduciary investors to our Cayman hedge funds are increasingly looking to assess the corporate governance structure prior to investing - to better understand the capabilities, conflicts and capacity of the appointed directors,” he said.
In another article for the Cayman Financial Review Campbells partner Ian Dillon argued that although many commentators have been quick to applaud the general requirement for strict corporate governance promoted by the judgment and used the court’s decision as a marketing tool, the obligations as spelled out by the judgment seem to suggest a level of supervision not commonly seen in the industry.
“Although it may be valid to claim that the fact pattern in this case doesn’t follow standard industry practice the tests as set out by the learned judge do not, in my view, represent industry practice either, and further, if most Cayman Islands independent directors are honest, nor do such tests represent their practice,” Dillon wrote.
Dillon refers particularly to the launch phase of the fund for which the court seems to suggest directors cannot simply rely on the work of lawyers but have to review the fund’s documentation and second guess the conduct and work of lawyers, accountants and other professionals.
The judge said that “whilst the involvement of reputable and experienced lawyers is obviously helpful from the directors’ point of view, it is important to understand that the lawyer’s duty to their client is quite different from that of the director’s duty to the company”.
Dillon does not see such a conflict between the advisors of the investment manager and the fund itself at the time when the fund is established. While those interests may diverge in the future, “surely at this time in a fund’s life all of the interests are aligned”, he writes.
One fund governance firm at least maintains that for them it is current practice and it may actually lead to conflicts with the investment manager’s legal counsel. Linford said he reviews the funds documentation and delegation of authorities. “We therefore share our views with the investment manager and other service providers on fund documentation based upon our experience with the expectations of leading fiduciary investors. On rare occasions this can lead to some friction with the legal counsel of the client but mostly it leads to a constructive discussion with all service providers, enhanced and clearer language in the fund offering document and less chances of friction in the future,” he said.
Linford believes that fiduciary investors will incorporate additional questions into their director due diligence questionnaires based on the judgment.
According to Ridley the result of the judgment should be that the business of providing independent director services should be left to those with the necessary expertise and risk management tools. “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,” he said.