Seamus Andrew & Niall Goodsir-Cullen wrote the following article in January, 2007, under the title “Accountability of Cayman Islands directors”:

The Cayman Islands is the number one domicile in the world for hedge funds and structured finance transactions and one of the ten largest banking centres – but how accountable are the directors of the companies based there?

There are 8,972 investment funds, over 80,000 active companies and hundreds   of    specialist bankers, lawyers and accountants in the   Cayman Islands, and over US$1.4 trillion on deposit. The Cayman Islands continuing success is due in part to laws that reflect the increasingly complex requirements for a successful offshore financial centre. It might seem surprising, therefore, that the vast majority of directors of Cayman Islands companies appear to operate free from legal responsibility to the company for negligence as a result of directors’ indemnity and exculpation clauses in the articles of Cayman Island companies.

Omission of section 205 of the Companies Act 1948

This potential encouragement to overly relaxed corporate governance was addressed over fifty years ago in the UK by a statutory provision that is designed to keep directors on their toes. While the Companies Law (2004 Revision) of the Cayman Islands is substantially based upon the English company law statutes of 1862, 1929 and 1948, there are important differences and one of them is the omission of section 205 of the Companies Act 19482. Section 205 was enacted to render void the then well established English legal principle that a company, under its articles of association, could exempt directors from liability for their negligent management of the company3. In the Cayman Islands, there is no such statutory provision and, accordingly, no statutory bar to articles of association providing for director exemptions. Consequently the articles of association of a Cayman Islands’ company typically contain indemnities and exculpations to relieve directors from liability for negligence, gross negligence and wilful default.

The move to greater accountability

However, whether the courts might consider it acceptable for a Cayman Islands company to hold its directors harmless for their negligent mismanagement might now be open to doubt. Not only has the law relating to the duties of directors moved on since 19255 and the case of Re City Equitable Fire Insurance Co. Ltd. [1925] Ch. 407, but there is also an issue of public policy, namely that good corporate governance requires directors to be held accountable for their management of a company. It seems perverse that a Cayman Islands company should be statutorily required to keep proper books of account, but at the same time it should be allowed to hold legally harmless the very people whose job it is to ensure that the company fully complies with its statutory obligations, even if they are guilty of wilful default.

Recent case law is not easy to come by twice, in 1911 and 1925, the English High Court determined that such clauses were valid (although no court higher than first instance was asked to examine their validity). Thereafter there is a dearth of English authority because of the English statutory ban. The Privy Council considered such a clause in 1986, on appeal from the Royal Court of Jersey, and found that such a clause could be construed so as to confer protection in respect of an act ultra vires the company. In 1990 the Cayman Islands Grand Court applied Romer J’s definition of ‘wilful default’, from the decision of Re City Equitable Fire Insurance Co. Ltd, and found the directors of a Cayman Islands company liable for reckless carelessness amounting to willful default. In neither case did the company challenge the essential validity of the clause8. Such a challenge would almost certainly be made in a similar case now.

‘Gross negligence’ and ‘wilful default’

Quite apart from the question of whether such clauses are enforceable, there is scope for disagreement as to their breadth, and in particular as to the meaning of ‘gross negligence’, and ‘wilful default’

Although ‘gross negligence’ appears in certain articles of association, it is unlikely to assist a director substantially, because the English common law does not recognise ‘gross negligence’ as a separate concept from ordinary negligence. Therefore a director relieved from liability, save where he has committed gross negligence, is probably liable for ordinary negligence.

However, ‘wilful default’, it is submitted, is more difficult to interpret. In Re City Equitable Fire Insurance Co Ltd Romer J interpreted this expression to mean that the director must know ‘that he is committing, and intends to commit, a breach of his duty, or is recklessly careless in a sense of not caring whether his act or mission is or is not a breach of duty’. By contrast, in the Australian case of Dalrymple v Melvill (1932) 32 SR (NWS) 596 Long Innes J held that the defendant ‘must have known that, in omitting to take the precautions which he ought to have taken, he was committing a breach of his duty, and whether he was recklessly careless or not is immaterial’. In practice the culpability necessary to surmount the ‘wilful default’ hurdle may not be as great as one might assume from the label.

Director Services Agreement

The analysis of directors’ indemnities in the Cayman Islands is further complicated by the fact that the directors of a Cayman Islands company will often be provided under a ‘Director Services Agreement’. Intuitively, one would assume that a degree of responsibility for the actions of the ‘provided directors’ should attach to the service provider. However, the Cayman Islands Court of Appeal held in Paget- Brown and Company Limited v. Omni Securities Limited [1999] CILR 185 that in the absence of an express or implied contractual obligation on behalf of such a service provider to monitor the performance of the ‘provided directors’, and in the absence of fraud or bad faith on behalf of the service provider, the service provider does not owe a duty of care to the company or its creditors to ensure that the ‘provided directors’ performed their functions diligently or competently.

The wind of change?

Needless to say, the Cayman Islands remain a recognised world financial centre. Great strides have been made to develop the legal and regulatory infrastructure to ensure that it meets and often exceeds the standards of the global financial community. Nevertheless the prevalence of director indemnities and exculpations raise a potential concern for the many investors in mutual funds incorporated in the Cayman Islands and other offshore financial centres, particularly as indemnities are often not disclosed in the offering documents. These lacunae need to be addressed if the Cayman Islands is to remain the jurisdiction of choice for funds.

Seamus Andrew is the managing partner at Simmons/Cooper/Andrewand Niall Goodsir-Cullen is a is a consultant at Chris Johnson Ltd.

References:

Cayman Islands Monetary Authority, official statistics for second quarter 2007.

Section 205, Companies Law 1948 is the predecessor section to Section 310, Companies Law 1965, now Section 232, Companies Law 2006.

Re Brazilian Rubber Plantations and Estates Ltd [1911] 1 Ch. 425.

This list is not exhaustive

See, for instance, Dorchester Finance Co Ltd v. Stebbing (1977) [1989] BCLC 498; Re D’Jan of London Ltd [1994] 1 BCLC 561; Norman v. Theodore Goddard (a firm) [1991] BCLC 1028; and Re Barings plc [1999] 1 BCLC 433.

Section 59 Companies Law (2004 Revision).

Viscount of the Royal Court of Jersey v. Shelton [1986]1 WLR 985.

Prospect Properties Limited (in liquidation) v. McNeill and J.M. Bodden II [1990-91] CILR 171.

It is settled law that a clause purporting to exclude fraud is beyond the pale and will not be enforced. Nevertheless such clauses are occasionally seen. They are usually unenforceable in their entirety.

Lord Cranworth in Wilson v. Brett (1843) M&W 113 said that ‘gross negligence is ordinary negligence with a vituperative epithet’. This was recently affirmed by the English Court of Appeal in the case of Tradigrain S.A. v. Intertek Testing Services (ITS) Canada Limited [2007] EWCA CIV 154: ‘The term gross negligence, although often found in commercial documents, has never been accepted by English law as a concept distinct from simple negligence’.

End

On 26^th August, 2011, in Weavering Macro Fixed Income Ltd (In Liquidation) v Peterson the directors of a corporate investment fund had failed to apply their minds to the activities of the company and were essentially puppets of the investment manager. They took orders from the investment manager and rubberstamped any documents put before them for more than six years while offering no form of effective supervisory role. The fund collapsed and the directors were found personally liable for neglect of US$111M.

The lesson is that the duties of a fiduciary are onerous and require independent thought and careful consideration.

Victor Murray wrote an article appearing in MG Management Ltd website about the Weavering Case:

Following the Weavering decision what should a Cayman Islands fund expect from their directors?

Although the recent Weavering case (Weavering Macro Fixed Income Fund 26 August 2011) did not create any new law, it does provide some insight as to the basic minimum standards that should be expected from a fund director at least by the Cayman Islands Court.

In the Weavering case the directors of the fund were found not to meet basic standards in relation to the discharge of their fiduciary obligations. The judge in the case stated that the Cayman Islands funds industry “…works on the basis that investment management, administration and accounting functions will be delegated to professional service providers and a company’s independent non-executive directors will exercise a high level supervisory role.” There was no evidence of the directors of Weavering asking any questions of any service providers.

The judge further went on to say that the directors of the Cayman Islands fund must:

have relevant experience in the review of offering documents to ensure that the fund offering documents fairly describes the offering of its investments;
exercise their duty to review all the funds service agreements and satisfy themselves that each is appropriate and consistent with industry standards to ensure a division of responsibility amongst all the service providers (the case also stated that this is not a task that can be delegated to the lawyers retained by the investment manager); satisfy themselves on a continuing basis that the fund service providers are performing their functions in accordance with the relevant agreements;

actually hold regular board meetings where minutes are taken which fairly and accurately record the matters considered and the agenda should be prepared with input from the funds service providers before the meeting;
be able to understand the funds financial statements and the audit process;
exercise independent judgment in respect of all matters falling within the scope of their supervisory responsibilities.

These basic duties to be undertaken by a fund director are not (and should not be) a surprise to any professional director.

The general focus of the decision is that independent directors should be expected to provide a certain amount of investor protection following the establishment of the fund, whilst recognizing that they may delegate the core functions of the fund. The directors have a duty to ensure that the service providers are actually carrying out their delegated services correctly. It is difficult to envisage how a director affiliated with investment manager, or other service provider, can be seen to exercise independent judgment no matter how competent as the suggestion that they were influenced by their connection can be levied as in the Weavering case.

It is clear (as it always has been) there are many drivers requiring the appointment of independent directors to a fund and the recent Weavering case simply underscores this requirement.

For more go to:

http://www.mgcayman.com/weavering-case/

In November, 2011, Francis Kean wrote an article under the heading “Offshore Directorships: How Many Are Too Many?”

First we had the Weavering case, shedding light on the standard of care expected by the Grand Court of the Cayman Islands of independent directors in offshore hedge funds. Now we have a front page exposé in this week’s Financial Times on the Cayman Islands hedge fund industry in general.

Perhaps this is no surprise as, according to the FT, there are an estimated 8,000 hedge funds located there, or approximately three-quarters of the whole industry. The article says that “at least four individuals [in the Cayman Islands] hold more than 100 non-executive directorships each and 14 have more than 70.”

Multiple directorships are neither a new phenomenon nor one restricted to the Cayman Islands, but they raise this obvious question: How many directorships can or should individuals sensibly hold if they are to discharge their supervisory function adequately?

Of course not all directorships are the same and certain roles plainly require a lot more time and commitment than others. Even restricting the question purely to offshore funds, however, it’s not an easy one to answer and indeed has a bumpy history.

Echoes of Sark

In the 1990s, pretty well the majority of the 600 islanders resident on Sark in the Channel Islands were in one way or another involved in the business of supplying company directors to offshore funds. One in particular gained notoriety.

In January 1999, shortly before his disqualification by the Guernsey Court, Phillip Crowshaw was a director of well in excess of 3,000 companies, each of which paid him a modest fee for the use of his name.

It is not hard to see that at that end of the spectrum, individuals such as Mr Crowshaw would have been in grave peril of a finding of “wilful default” along the lines of the judgment of the court in the Weavering case.

Who Decides?

But how many is too many and who should decide? In particular should it be the courts? After all they can be an expensive and blunt instrument and (more importantly) can only decide on the facts after the relevant events have occurred. Perhaps the answer lies instead with those responsible for the regulation of each offshore center?

After all, the demise of what became known as the Sark Lark came as a result of new legislation introduced by Guernsey’s Financial Services Commission under which it assumed much stronger powers in effect creating a licensing system for company directors. Until such systems are introduced in all recognized offshore centers, the risk of further findings of wilful default or their cross border equivalents will remain.

For more on this story go to:

http://blog.willis.com/2011/11/offshore-directorships-how-many-are-too-many/

The Cayman Islands Director’s Association (CIDA) has also asked the same question.

There have been increased discussion over the last year regarding possible regulation of the types of persons who may act as directors of Cayman Islands’ domiciled investment funds including the manner in which such directors fulfill their duties.

Maybe it is already past time.