By David Butler ▪ Harney Westwood & Riegels, Sean Scott ▪ Harney Westwood & Riegels LLP – From CDR Commercial Dispute Regulation

David Butler and Sean Scott of Harneys examine the impact of an appeal in the Cayman Islands which found two former non-executive company directors had not acted with wilful neglect.

Following the collapse of the Weavering Macro Fixed Income Fund (the Fund) in 2009, owing largely to fraud by the investment manager, the liquidators appointed to the Fund brought claims against the directors in the Cayman Islands.

The case against the directors was that they breached their duty of supervision by failing to identify, by the latest in November 2008, that a substantial proportion of the fund’s investments were interest rate swaps, the counterparty to which was a related fund (WCF).

Justice Andrew Jones at first instance found that if the directors had identified this fact (set out in a report which had been produced for the board in 2008), they would have appreciated that the values attributed to those investments in the Fund’s financial statements could not be justified.

In fact, the Fund was insolvent and should (and would) have been wound up. Following the collapse of Lehman Brothers there had been a large number of redemption requests, which had then been paid by the Fund.

The liquidators alleged that had the directors performed their duty of supervision, the Fund would have been placed into liquidation sooner and the redemption requests would not have been satisfied.

The allegations were much broader than this: at its heart, the breach of duty complained of was the failure of the directors to pick up on the fact that WCF was the counterparty, when it was stated in the quarterly report, and for them to act accordingly in light of that knowledge.

The directors disputed that they breached their duty, but said that, even if they had done so, they were entitled to rely on the exculpation clause in the Fund’s articles of association, which excluded the directors from liability for their conduct except when guilty of “wilful neglect or default”.

The allegations against the directors were accepted by the Financial Services Division of the Grand Court in the subsequent proceedings, and Jones J found that the directors did breach their duty and were guilty of wilful neglect or default.

It was held that the directors’ default had caused the Fund to suffer losses of at least USD 111 million (being the difference between what was actually paid by the Fund and what would have been paid out had the fraud been identified). The trial judge gave judgment against each of the directors for that sum in 2011. The first instance judgment was subsequently appealed and has been a significant industry talking point since.

APPELLATE VICTORY

On 12 February 2015, the Cayman Islands Court of Appeal handed down its long-awaited judgment in Weavering Macro Fixed Income Fund Ltd v Peterson and Ekstrom. The judgment allowed the appeal against the first instance judgment and set aside damages of USD 111 million.

The President of the Court of Appeal (with whom the other two judges agreed) disagreed with the trial judge that the directors breached their duty to supervise the Fund’s business, which, as in most Cayman investment structures, is carried on by delegates such as investment managers, administrators, custodians and so forth.

The duty essentially consists of selecting appropriate delegates, ensuring that the terms on which they are appointed give effect to the investment objectives and restrictions set out in the offering documents of the Fund, and ensuring that they perform properly the functions which are delegated to them.

AT FIRST INSTANCE

Jones J had held that the directors were guilty of wilful neglect or default and that they could not therefore rely on the exculpation clause in the articles of association. Jones J directed himself that in order to amount to “wilful neglect or default” the directors must have either known that they were committing, and intended to commit, a breach of duty, or were recklessly careless in the sense of not caring whether an act or failure to act is, or is not, a breach of duty.

He said that the case against the directors was that “they did nothing” and carried on doing nothing for almost six years. Finding that their neglect to act must have been intentional, the judge held that if the evidence had established that the directors had utterly ignored, and made no attempt to perform, their duty, in spite of being conscious of that duty to supervise, “then their default must be regarded as wilful”.

“The purpose and effect of [the exculpation clause] is 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 serious attempt… to perform the duty are not relieved from liability.”

The ruling found the directors were guilty “because they consciously chose not to perform their duties to the [Fund] or at least not in any meaningful way”. For good measure, he added, “if they had applied their minds for a moment, they would have appreciated that their behaviour was wrong”.

THE COURT OF APPEAL RULING

The Court of Appeal disagreed with the reasoning of the first instance decision. It could find nothing in the evidence to support the findings Jones J had made or the inferences which he had drawn which led him to conclude that the directors were guilty of wilful neglect or default.

In order to show wilful neglect or default the Court of Appeal held it was necessary for the Fund to prove that the directors made a deliberate and conscious decision to act, or to fail to act, in knowing of a breach of duty.

Equally, it might be necessary for the court to be satisfied that the director appreciated (at the least) that his conduct might be a breach of duty and made a conscious decision that nevertheless, he would do, or omit to do, the act complained of without regard to the consequences.

The Court of Appeal’s disagreement with Jones J, as to the findings he had made and inferences which he had drawn from the evidence, was extensive. It found the trial judge had been wrong to conclude that the directors’ failure to keep accurate minutes of meetings was evidence of a conscious decision to disregard their duty.

The appeal court also found that the evidence that the directors had never summoned delegates to meetings to be questioned could not be taken as evidence of a decision not to perform their duties. It found the directors were entitled to take the view that they could rely on the written reports that were produced for them by the administrator.

Equally, while the trial judge had found that the directors’ decision to sign documents which they had not read was evidence of wilful neglect, the higher court disagreed. The court held that directors who sign documents which, on their face, appear to be documents which they can properly be advised to sign, and which they have been professionally advised to sign by those who have considered that it is in the Fund’s interests such documents be signed, are not in breach of a high-level supervisory duty.

The Court of Appeal also criticised the trial judge’s identification of the scope of the high-level supervisory duty, by reference to his own expectations of what the directors should have done without reference to authority, and on a rigid and overly prescriptive view.

The President observed that: “It may be said that the conduct of the directors which the judge criticised… is consistent with the judge’s conclusion that neither of the directors ever intended to perform his duties.”

He added, however: “It is equally consistent with an understanding on the part of the director concerned as to what the high-level supervisory duty required which differed from that of the judge; and, it is equally consistent with negligence, or gross negligence in the performance of whatever the directors believed the high-level supervisory duty required of them.”

Even though the Court of Appeal disagreed with Jones J as to his ruling, in what was admittedly an extreme case, there is little doubt that, when published, the judgment at first instance served an important and useful purpose in ensuring all those operating in all corners of the Cayman funds industry sat up and took serious notice of what had been said by the court.

Many Cayman service providers reviewed their governance models and standard documentation to make sure that roles and responsibilities were more clearly defined and delineated. Weavering has also generated a public consultation concerning fund governance issues and has led to legislation regulating certain providers of professional directorships.

In short, it is unlikely that the changes which Weavering has brought about will be forgotten or reversed.

The Court of Appeal’s reiteration of the test for wilful neglect and default reminds us that the bar for liability is set very high and that professional service providers can escape liability even where they have been responsible for the grossest default, as long as it was not wilful.

The question which may now become the focus of debate is whether wilful default remains the appropriate standard for the Cayman Islands’ sophisticated professional funds industry in the 21st century.

David Butler is a partner in Harneys’ Cayman litigation and insolvency department. He joined Harneys in 2013 from the Cayman office of another global offshore firm. David’s practice focuses on commercial disputes involving all forms of Cayman Islands corporate, partnership and trust structures, fraud, asset-tracing and preservation, and insolvency and restructuring work.

Sean Scott is a partner in Harneys’ London office and is part of the team responsible for the firm’s Cayman practice in Europe. He advises on the establishment and maintenance of all types of Cayman Islands hedge, venture capital and private equity funds. He also has extensive experience of a wide range of corporate, banking and finance matters.

SOURCE: http://www.cdr-news.com/categories/litigation/5603-after-weavering-wilful-default-deciphered