Editor’s note: This publication is grateful to Carne Group for being able to republish this expert commentary on an important recent Cayman Island ruling. Comments are from John Donohoe, chief executive at Carne Group. The comments examine the implications for investment managers and employees acting as directors on funds.

On 26 August 2011 Mr Justice Jones of the Grand Court of the Cayman Islands delivered his judgement against the directors in the case of Weavering Macro Fixed Income Fund Limited (In liquidation) vs Stefan Peterson and Hans Ekstrom (“Weavering”): $111 million for directors’ wilful neglect or default.

There was no new law, no new statute and nothing you could argue against. So why is it imperative that every investment management firm as well as every fund director, (whether they are directors related to the investment manager, service providers or independents) read the judgement themselves in full?

The answer is that, written in plain English, it represents the minimum expectations of a court regarding fund corporate governance as well as demonstrating that poor corporate governance is a business risk to the manager as well as a personal risk to all fund directors including those from the investment manager’s firm.

The case against the directors was:

They acted "in breach of their duty to exercise independent judgement" and;

They failed "to exercise reasonable care, skill and diligence" and;

They failed "to act in the interests of the Macro Fund"

Directors’ duties, conflicts of interest and motivation

Justice Jones stated that: "Directors owe fiduciary duties to their companies to act bona fide in what they consider to be the best interests of the company . . . and not to place themselves in a position where there is a conflict between their personal interests and their duty to the company". "A director must exercise his powers independently" and "directors have a duty to exercise an independent judgement in what they consider to be the best interests of the company which, in this context (inception of fund), means its potential investors".

Justice Jones extended directors' responsibilities to on-going investors when the fund is up and running as well as "potential investors". The reality is that situations occur where fund directors from the investment manager may be conflicted in relation to their own / firm’s interest versus the investor’s interests. These include valuations, side pockets, supervision and side letters. For example in relation to side letters, Justice Jones notes that "the execution of side letters is a complicated subject... it is inevitable that investment managers will be under pressure to accommodate those seeking to impose side letters".

Due to potential conflicts of interest it is compelling that the fund directors that are related to the investment manager need "independent directors" on the board as they can assist with conflicts as they arise. Justice Jones concluded that not only must boards consider the best interests of investors over and above others but "minutes must be taken which fairly and accurately records the matters which were considered and the decisions which were made” i.e. the board must do the right thing, be seen to do the right thing and be able to prove they did so. Without professional independent directors, who are of the right culture and motivation as discussed below, how can this process work so as to protect the "manager director", his or her own assets and the investment manager’s business.

Business risk to investment managers and personal risk to "manager director"

Will any type of independent director protect the investment manager and its representative director on the board?

Absolutely not according to Justice Jones. He or she must be a director who acts in a professional manner.

What did the judge look for?

Motivation and culture: If independent directors “were never paid any fees” or relatively low fees or have an excessive number of directorships it “supports the case that they never intend to perform their duties, or at least not in a serious way, and were merely lending their names to the Macro Fund”. The judge examined in detail whether the director(s) “ behaved as if he had any intention of performing his duty to supervise”.

Skills and experience: “They must exercise care, skill and diligence” and “are expected to act in a professional, business-like manner”.

They and not others must supervise: “Each director owes duties to the company to inform himself about its affairs” “without subordinating those powers to the will of others”. They are “expected to acquire a proper understanding of the financial results”, that the fund is “complying with whatever investment criteria and restrictions” and “that the various service providers are performing their functions” etc. “This means that they must do more than react to whatever problems may be brought to their attention” and “review in an inquisitorial manner and make appropriate enquiries of those involved”. They cannot merely provide “what counsel described as an “administrative service”. Boards must hear directly from all parties to the fund on a regular basis.

Apply their minds: Although Justice Jones did not expect the directors to be experts in every field he expected them to “apply their minds” to what they were doing and not rely solely on the explanations of others.

Must document: Agendas and board packs must be prepared and there is “a duty for minutes to be taken” which allows a future “reader to understand the basis upon which the decisions were made” and how the fund was supervised. Justice Jones was damning in his conclusion that there was “no documentary evidence reflecting that these directors ever sought to discuss or enquire about any subject at all”. The Judge concluded that the minutes in this case were “designed to give the impression that they were functioning as a board of directors, whereas in reality they had not read the material sent to them and had made no attempt to understand the Macro Fund’s financial condition”. Justice Jones wanted evidence that the Directors were doing their job properly.

Conclusion

Investors are as nervous now as they have been over the last three years about various risks. To attract and retain capital, investment managers should understand this and work with investors to mitigate operational risk through high standards of corporate governance. However Weavering demonstrates that when it comes to corporate governance, the interest of the whole industry including investors, investment managers, their principals and directors are aligned and it is a win-win for all involved. Professional independent directors who are motivated to do the job properly are key to this.