Wilful Neglect or Default and a Cayman Director's "High-Level" Supervisory Duty

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Wilful Neglect or Default and a Cayman Director's "High-Level" Supervisory Duty

By Alric J. Lindsay


Introduction

 

Depending on its legal structure, a Cayman Islands corporate fund would normally have a board of directors which is responsible for the overall supervision of the fund.   In order to assist with the execution of functions related to the ongoing operation of the fund, it is customary for the day-to-day investment decision making functions to be delegated to the fund’s investment manager and for the day-to-day fund administration functions to be delegated to a fund administrator.  The directors of a Cayman fund are said to have a “high-level” supervisory duty in relation to the performance by service providers of the functions delegated to them.  This “high-level” supervisory duty and breach thereof were discussed in the recent Cayman Islands Court of Appeal (“COA”) case of Peterson and Ekstrom V. Weavering Macro Fixed Income Fund Limited (In Liquidation) (the “Weavering Case”).  As a second issue, the COA discussed whether the failure of each director to discover the identity of a counterparty to certain contracts was a result of his own wilful neglect or default.  These two issues are highlighted below.

 

Nature/Scope of High-Level Supervisory Duty in the Weavering Case

 

In the Weavering Case, the board of directors of Weavering Macro Fixed Income Fund Limited delegated the investment decision making functions to the fund’s investment manager and delegated the fund administration functions to its administrator.    It was taken as a correct view in that case that the duties that the directors owed to the company included a “high-level” supervisory duty in relation to the performance by the service providers of the functions which had been delegated to them.

 

The “high-level” supervisory duty required (at the least) the directors to take the necessary steps to meet the objectives which they had set themselves when the company was established.   As recorded in the minutes of the board meeting held on the relevant date, the directors acknowledged that it was “essential that the investment manager act within the guidelines and investment restrictions set by the Board.” They resolved that that requirement would be “closely looked upon at each board meeting”, and decided that board meetings were to be held quarterly, in October, February, April and July in each year.

 

What Each Director Should do to Properly Discharge his High-Level Supervisory Duty

 

In the Weavering Case, quarterly reports from the fund administrator were the only means independent of the investment manager by which the directors sought to satisfy themselves that the investment manager was acting within the guidelines and investment restrictions which they had set.

 

The fund administrator’s quarterly reports contained, on the final page, a section headed “Errors and Breaches.”   It was under that section, if at all, that the directors could expect to find notice from the fund administrator that investment restrictions had been breached.

 

The COA found that in those circumstances, and for the purpose of each quarterly board meeting, if the directors were to meet the objectives which they had set themselves in the board meeting around the time that the company was established, it was necessary for them to: 

    • read the final page of each quarterly report in order to satisfy themselves that it did contain the usual section “Errors and Breaches”, and 
    • determine from such review whether any breaches of restrictions were reported. 

Such a review would require the exercise by the directors of a degree of care and skill.  The duty of care and skill (albeit in the context of a “high-level” role) would require the directors to read the relevant lines of text within the relevant section of the company’s quarterly reports in order to inform themselves (even in the most general terms) as to what the section contained.  Only by the proper exercise of such duty of care and skill could the directors be in a position to make a statement in the board minutes as to whether or not the investment manager had breached the guidelines and investment restrictions set by the board.    In this case, the COA found that the directors failed to exercise the degree of care and skill which the “high-level” supervisory duty required of them because they did not “pick up” on or “missed” information in the fund administrator’s quarterly reports.   In particular, the directors missed information indicating the identity of a counterparty and did not pick up on the fact that the company had breached the investment restrictions of the company set out in its offering memorandum which stated that “no more than 20% of the value of the Gross Assets of the Company is [to be] lent to or invested in the securities of any one issuer . . . or is exposed to the creditworthiness or solvency of any one counterparty”.  This happened primarily because the directors were simply speed reading or skimming some sections of the reports.   By acting in this manner, the COA found that the directors failed to take the steps which were necessary for that purpose, given the manner in which they sought to meet the objectives they set themselves at the company’s inception.

 

Wilful Neglect or Default

 

Having established the foregoing, the COA considered whether the failure of each director to discover the identity of the counterparty was a result of his own wilful neglect or default.   If the directors were guilty of wilful neglect or default, they would be unable to rely on the indemnity contained in article 182 of the articles of association, which was in the following terms: “Every Director, agent or officer of the Company shall be indemnified out of the assets of the Company against any liability incurred by him as a result of any act or failure to act in carrying out his functions other than such liability (if any) that he may incur by his own wilful neglect or default. No such Director, agent or officer shall be liable to the Company for any loss or damage in carrying out his functions unless that liability arises through the wilful neglect or default of such Director, agent or officer.”

 

In order for the COA to determine whether the failure of each director to discover the identity of the counterparty was a result of his own wilful neglect or default, the COA examined the tests set out in Romer, J’s judgment In re City Equitable Fire Ins. Co. Ltd (the “City Equitable” case).  According to Romer, J’s judgment, the tests comprised two distinct limbs: a director will not be liable for breach of duty unless he either (a) knows that he is committing, and intends to commit, a breach of his duty; or (b) is recklessly careless in the sense of not caring whether his act or omission is or is not a breach of duty.


In the lower court of the Weavering case, the Grand Court judge found that the case against the directors lay within the first limb of Romer, J.’s test. 

 

The COA concluded that: 

    • It is clear on the authorities referred to that, in order to establish “wilful neglect or default” for the purposes of defeating the protection given to directors under an article in the terms of art. 182 of the company’s articles of association, it is necessary (at least under the first limb of Romer, J.’s test in the City Equitable case) for the company to prove to the satisfaction of the court that the director made a deliberate and conscious decision to act or to fail to act in knowing breach of his duty. Negligence, however gross, is not enough. 
    • There was no specific evidence that either of the directors made a deliberate and conscious decision not to read the Q3 2008 Report with sufficient care to satisfy himself that there had been no breach of the investment restrictions, knowing that failure to do so was a breach of his duty. 
    • The Grand Court judge’s finding that one of the director’s signatures on board minutes dated December 23rd, 2008, which appeared to record proceedings at meetings of the directors on July 29th, 2008 and October 28th, 2008 that had not taken place, led “unequivocally to the conclusion that they both knew perfectly well that their behaviour was wrong,” could not be supported.  The COA found that there was no reason for treating the signature on the minutes of December 23rd, 2008 as evidence of a dishonest attempt to cover up the true position rather than as evidence of the directors’ general incompetence in relation to board minutes. 
    • The Grand Court judge was wrong to treat the directors’ failure to require anyone from the company’s administrator, investment manager/advisor or auditors to attend board meetings, or to give a written or oral report as to the position of the company, as evidence of a decision, generally, not to perform their duties as directors of the company. Further, in the COA’s judgment the directors could reasonably take the view that they could rely on information contained within the section of the quarterly reports from the administrator headed “Errors and Breaches” to alert them to breaches of the investment restrictions..”  
    • The Grand Court judge was right to criticize the directors for signing documents without reading them.  However, directors who sign documents which they have read, which appear on their face to be documents which they could properly be advised to sign, and which they are advised by those who may be taken to have considered whether or not in the interests of the company it is appropriate for them to sign, are not to be held in breach of a high-level supervisory duty. A fortiori, a director’s decision to sign such documents is not generally to be taken as a decision not to perform the duties which he owes to the company. 
    • It was not open to the Grand Court judge to draw the inference that each director had each consciously chosen, generally, not to perform his duties to the company.  The Grand Court judge was wrong to hold (if and in so far as he did) that either of the directors had made a deliberate and conscious decision not to read the Q3 2008 Report with sufficient care to satisfy himself that there had been no breach of the investment restrictions, knowing that failure to do so was in breach of his duty. 

The COA therefore held (for the above reasons) that the directors were not guilty of wilful neglect or default under the first limb of Romer, J.’s test in the City Equitable case.

 

The COA also explored the second limb of Romer, J.’s test in the City Equitable case i.e. that a director will not be liable for breach of duty unless he is recklessly careless in the sense of not caring whether his act or omission is or is not a breach of duty. 

 

Regarding the second limb of the City Equitable test, the COA concluded that: 

    • In order to establish the liability of a director under the second limb of the City Equitable test, it is necessary to satisfy the court that the director appreciated (at the least) that his or her conduct might be a breach of duty and made a conscious decision that, nevertheless, he or she would do (or omit to do) the act complained of without regard to the consequences.  If the evidence does not establish that the defendant at least suspected that his conduct might constitute a breach of duty, it is not appropriate to characterize his breach of duty as “wilful neglect or default,” whether under the first or the second limb of the City Equitable test. To hold otherwise would, in the COA’s view, be to fail to give full meaning to the requirement that the “neglect or default” relied upon must be “wilful.” 
    • In so far as reliance on the second limb of the City Equitable test is founded on the contention that liability for loss caused by “wilful neglect or default” of duty under that limb requires no conscious appreciation on the part of the directors that their conduct might be in breach of duty, it must be rejected. The COA found no support in the evidence that the directors had the requisite conscious appreciation that they might be breaching their duty to read the Q3 2008 Report with sufficient care to discover the identity of the counterparty to the relevant contracts. 

Based on the lack of evidence and the specific circumstances of the case, the COA found that, even though the directors had breached their “high-level” supervisory duty, they were not guilty of wilful neglect or default under either the first or second limb of the City Equitable test and as such were able to rely upon the indemnity provision in article 182 of the company’s articles of association.

 

What Does It All Mean?

 

Directors of corporate entities in jurisdictions which rely on common law may wish to consider the judgment handed down by the COA of the Cayman Islands.   It is possible that the courts of such jurisdictions may take a similar approach by examining in detail the specific circumstances of the relevant case to determine whether, based on the facts, there is sufficient evidence of a breach of directors’ duties and if there is such evidence, whether there are any indemnity and exculpation provisions within the company’s constitutional documentation to protect them.

 


 

Alric Lindsay is a Senior Associate in the Investment Funds practice group of Higgs & Johnson, Cayman Islands. He advises on all aspects of investment funds, specialising in private equity and hedge fund formation. He previously worked as an investment funds attorney for Maples and Calder, as well Ogier, in the Cayman Islands. Prior to qualifying as an attorney, Alric qualified as a certified public accountant with PriceWaterhouseCoopers. Alric also worked as a regulator with the Cayman Islands Monetary Authority. Mr. Lindsay can be contacted at alindsay@higgsjohnson.com 

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Grand Cayman,
Friday, March 3, 2017
Business Organizations, Corporate