The Fund
The Fund had entered into various interest rate swaps (IRSs) with a related entity Weavering Capital Finance. They were apparently heavily in the money. However, in early 2009 the Fund collapsed when the IRSs were found to have been fraudulently created by the principal of the Fund’s investment manager, Magnus Peterson.[2] The Fund was structured in the usual way, contractually delegating responsibilities for investment strategy and trading to an investment manager and accounting functions to a professional administrator, and it was subject to an external, independent audit by professional auditors. The Fund’s shares were listed on the Irish Stock Exchange.
The only unusual feature in the structure was that the sole directors of the Fund comprised Stefan Peterson (Magnus Peterson’s brother) and Hans Ekstrom (the Petersons’ elderly step-father, who was aged 79 at the Fund’s launch). On paper, Ekstrom and Stefan Peterson had appropriate professional credentials and they satisfied the ISE’s independence requirements.
The central allegation was that the directors had wilfully failed to discharge their duties of skill, care and diligence[3] to the Fund which, had they discharged them, would have caused them to discover the fraud and save the Fund considerable losses.
The directors had the benefit of the usual indemnity and exculpation provisions in the Fund’s articles of association. The provisions applied save in circumstances where the directors’ conduct amounted to wilful default. The Court adopted the familiar English authorities and held that the test for establishing wilful default was whether each director had either (1) knowingly and intentionally breached his duties to the Fund or (2) acted recklessly in the sense of not caring whether or not his acts or omissions were a breach of his duties.
It was common ground that the directors, being independent non-executive directors, had only a high-level supervisory role. It was the precise nature of that role in the particular circumstances of this Fund that was disputed and explored in the judgment. The Judge found multiple examples of misconduct by the directors throughout the life of the Fund. He found their misconduct to be so egregious that he inferred that they must have intended to breach their duties, so the indemnity and exculpation were not operative under head (1). Although the facts are extreme, the Judge made a number of observations about the role of independent directors of Cayman Islands funds that are of greater significance to the Cayman Islands funds industry than the particular findings against these directors.
Some sign-posts
Readers will appreciate that there is not a ‘one size fits all’ answer to how independent non-executive directors should discharge their high-level supervisory role and the facts of each case may result in a different approach being required of a board, but the Court has provided some useful sign-posts.
At a general level:
• independent directors must be proactive and not simply react to whatever problems or issues the fund’s other professional service providers bring to their attention. In the Judge’s words, they are not entitled to ‘assume the posture of automatons’ nor to assume that the service providers have performed all of their respective roles and responsibilities without any oversight or supervision whatsoever.
• the Court may have regard to the fees paid to independent directors when considering the nature and scope of their role. It may more readily infer that a director who is paid a substantial fee is expected to have more onerous responsibilities than one who is paid a modest fee. However, a director cannot divest himself of all responsibility by taking no fee at all.
At the fund establishment stage:
• independent directors have a duty to satisfy themselves that the overall structure of the fund is broadly consistent with industry standards and that the terms of the relevant service providers’ contracts are broadly reasonable and consistent with industry standards. They should understand the nature and scope of the responsibilities of each professional service provider so that they can appreciate who is doing, and not doing, what for the fund.[4] They should satisfy themselves that the scope of their own supervisory role was clearly understood by all concerned. The Judge thought that a mechanical review of the contractual documents would be unlikely to be sufficient for this purpose, especially if the promoter/investment manager is a start-up operation with no prior working relationship or experience with the other service providers, although he did not specify exactly how extensive this review process should be.
• every offering document should be verified, the purpose of which is to establish that it is both accurate and complete. This duty cannot be discharged merely by the directors obtaining comfort that the promoter/investment manager, relevant lawyers, prospective administrator and/or auditor are all reputable firms. The Court noted that, at the very least, the directors will need to make enquiry of the lawyers who have co-ordinated the work so as to gain a proper understanding of what has been done and with what result. Our view is that this does not mean verification of the offering document in the term-of-art sense (i.e. a line-by-line verification) but a mere practical preview and questioning of the appropriate parties to ensure that they are satisfied with the content of the offering document and that it properly describes the strategy of the fund and the relevant responsibilities of the directors and service providers.
• the directors should be active in the selection and appointment of the fund’s auditors, for example by reviewing their contractual terms of engagement and satisfying themselves that the terms are consistent with industry standards and are reasonable, including any limitations of liability. This may not be practical if the investment manager has preferred auditors for their fund platforms. Our view is that in such cases, the directors will at least have to be satisfied that the terms are not ‘off market’ and that the auditors are reputable and have the appropriate skills.[5]
During the ordinary course of a fund’s business:
• board meetings should be convened to discuss matters of substance and not simply to rubber stamp routine matters raised by the investment manager. When appropriate, independent directors should request specific reports from the fund’s investment manager or administrator. Before and after these meetings they should be properly documented (e.g. preparing and circulating an agenda in advance which affords the opportunity for input from relevant service providers and the directors, and preparing appropriate minutes afterwards) so that afterwards the directors are able to substantiate their decisions. Pro forma minutes will not always be appropriate but it is foreseeable that agendas for regular meetings considering routine matters may change little from meeting to meeting.[6]
• properly qualified directors should be able to read a balance sheet. They should review the fund’s monthly or quarterly management accounts so that they can properly understand the fund’s general financial/NAV position, which will help them play an active role in the annual audit process.[7]
Crisis management stage:
• independent directors are expected to make appropriate inquiries of other services providers and to hold meetings sufficiently frequently in order to make informed decisions on the financial state of the fund.8
Conclusion
In our view, where a Cayman Islands fund is established with independent directors it is in the best interests of the investors if those directors have relevant industry experience, are genuinely independent of the investment manager, and have the means and resources to carry out their duties throughout the life of the fund and are remunerated appropriately. Even if they have the advantages of an indemnity and exculpation, they should be ready, willing and able to ask questions of the fund’s service providers, to meet regularly to discuss the performance of the fund’s service provider and of the fund itself. Finally, if they are not happy with the responses that they receive, they have a duty to pursue their line of questioning to a satisfactory conclusion, no matter how uncomfortable that questioning may be.
1. Weavering Macro Fixed Income Fund Ltd (in liq.) v Peterson and Ekstrom. It is believed that the directors have filed an appeal.
2. Mr Magnus Peterson was the subject of an investigation by the UK’s Serious Fraud Office. It has recently been reported in English newspapers that the SFO has decided not to prosecute Mr Peterson.
3. There was no allegation that the directors had breached their fiduciary duties to the Fund.
4. In this case, the Judge found that if the directors had performed a proper oversight role from the outset, they would have realised that the administrator had contracted (as is often the case) on the express basis that it would not be responsible for monitoring the Fund’s compliance with the investment restrictions set out in the offering document.
5. This will have less relevance for funds regulated in the Cayman Islands because the Cayman Islands Monetary Authority publishes lists of approved auditors.
6. The Judge found that the directors played no active role in convening meetings, signed pro-forma minutes prepared by the investment manager without discussion or consideration, signed minutes of meetings that never took place, and never once sought a report from the investment manager or administrator in the six years from the Fund’s inception to its collapse.
7. The Judge found that if the directors had they reviewed the Fund’s available financial information they would inevitably have discovered the details of the fraudulent IRSs.
8. The Judge found that, despite the collapse of Lehman Bros and the ensuing credit crunch and make, the directors did nothing to question the counterparty risk with respect to the IRSs.