Following a series of landmark directors’ duties cases in the Cayman Islands, Senior Associate Lachlan Greig and Partner Katie Pearson explore the pressures faced by directors sitting on boards of Cayman Island funds.
The Cayman Islands is home to a modern and thriving investment funds industry with an estimated 75 per cent of the world’s offshore hedge funds and almost half of the estimated US$1.1 trillion of assets under management.
The directors at the helm of these funds typically benefit from contractual limits on, and indemnity against, the liability that might otherwise follow any shortcomings in their performance. These contractual provisions seek to strike a balance between giving directors the comfort to perform their roles robustly but without offering refuge for acts of an egregious nature. Nebulous terms such as ‘gross negligence’ or ‘willful default’ (to name a few) signpost the line of demarcation but what these terms mean is usually not obviously discernible.
This article discusses the rationale for these director protections, their structure and meaning, and some practical tips for directors when accepting an appointment to the board of a Cayman Islands fund.
Contractual allocation of risk
Risk allocation is a fundamental function of any contract, although the parties may not always consider it in those terms. For example, a contract for the sale of goods would usually specify the point in time at which title passes from the vendor to the purchaser – a point which may not necessarily correlate with either the taking of possession of the goods by the purchaser or with payment to the vendor.
The contractual limits or exclusions of liability, indemnities, exculpations, waiver of claims and variations of the same that appear in the articles of association of a Cayman Islands fund or director services agreements are the mechanisms for allocating risk in the context of investment funds.
These risk allocation provisions facilitate Cayman Islands funds to engage the skills and experience of independent professional directors at a relatively small cost compared to what otherwise might be sought by directors who face uncertain and unlimited liability in the performance of that function.
A recent decision of the Cayman Islands court has recognised that the global market for Cayman Islands investment funds depends on the availability and cost of independent professional directors and that indemnity provisions should be construed with that in mind.
Striking the balance
Unlike many other jurisdictions, there is no statutory restriction or regulation of limitation of liability or indemnity clauses in the Cayman Islands where (subject to limited exceptions) the law respects the rights of contractual counter parties to strike their own bargains. The exceptions include fraud and breach of a director’s core fiduciary duties to the company.
A party cannot contract out of the consequences of his or her own fraud for obvious public policy reasons and it follows that a director will not be able to rely on limitation of liability or indemnity clauses in relation to the director’s fraud regardless of whether the term ‘fraud’ appears in those clauses. Liability for breach of a core fiduciary duty cannot be excluded under equitable principles of the common law.
Left to their own devices, it is entirely for the directors and the fund to determine between themselves who will bear the risk of loss where a director fails to perform his or her function to the requisite standard. On the one hand, the fund wants to attract the reasonably priced services of professional directors to perform their functions commercially and robustly without constantly looking over their collective shoulders for fear of their own personal position.
The fund’s objective to maximise returns to investors does not sit easily with director liability. While fund failure is relatively rare, it does of course happen and the consequences are severe. On the other hand, for obvious reasons, a fund cannot offer blanket insulation from accountability.
As to where and how to draw the line, the approach uniformly adopted in the Cayman Islands fund industry is to offer umbrella protection subject to carve outs. The preferred formulation of those carve outs tend to be ‘fraud’, ‘gross negligence’, ‘willful default’ or ‘willful neglect’. As discussed below, these terms are not interchangeable – each has its own distinct meaning and captures a distinct form of behavior – yet it is very rare for all of these terms to be utilised in a singular clause.
A director who took the time to look for a definition of these terms in the fund’s articles of association would not usually find one. Experience suggests that a director may, in any event, do no more than check for the existence of limitation of liability and indemnity clauses that resemble a familiar – if not boilerplate – form in any event and does not engage with the specific terms of demarcation between liability and protection.
The proliferation of and apparent indifference to these terms might seem quite surprising given that they are not used in everyday commerce and do not have an obviously discernible meaning, including to many lawyers familiar with the investment funds industry.
It is usually only in the aftermath of a fund’s collapse that the meaning of these terms are considered under the harsh spotlight of the insolvency regime by the fund’s liquidators, directors and other stakeholders and their army of lawyers with a view to making or defending claims against directors, auditors and other service providers.
The precise meaning of these terms may well be litigated for many years afterwards and to the tune of millions of dollars. The litigious liquidations of several Cayman Islands-domiciled Madoff feeder funds continue to wind their way through the appellate courts some 11 years after the fraud was initially revealed: a recent decision of the Cayman Islands Court of Appeal considered whether the administrators and custodian of one such feeder fund had been ‘grossly negligent’ such that they could not avail themselves of the contractual protections from claims for negligence and breach of contract.
When tasked with determining high-value claims that hinge on the meaning of these terms, the courts have been careful to emphasise that they must be construed in the context of the documents in which they appear and that whether an act falls on one side of the line or the other will always be a fact sensitive analysis. These terms have eluded formulaic definition over the years and evolve with the times. Modern cases trace back to somewhat charming disputes about ship building or the 1877 English decision that considered whether the packing of Cheshire cheese by London railway men who, unlike Cheshire railway men, were unfamiliar with Cheshire cheese and the particular way it had to be packed to survive the train trip, comprised ‘willful misconduct’ by the London railway men.
The meaning of ‘gross negligence’ was recently revisited by the Cayman Islands Court of Appeal in Primeo Fund (In Official Liquidation) v Bank of Bermuda (Cayman) Limited (unreported, 13 June 2019). The Court explained that ‘gross’ negligence is simply negligence that is “very great”, “extreme” or “flagrant” or arises “by some really elementary blunder” – it is a question of degree, rather than a separate category, of negligence.
Acts of an advertent nature might fall within the carve out for ‘willful neglect or default’ if the director either acts (1) knowing he is committing and intends to committee a breach of duty or (2) is recklessly careless in the sense of not caring whether the act is a breach of duty (Peterson and Ekstrom v Weavering Macro Fixed Income Fund (2015).
The courts have considered there to be little difference between ‘fraud’ and ‘dishonesty’, comprising a two-step analysis of (1) what is the director’s state of mind and (2) whether the conduct is dishonest by the standard of ordinary, decent people.
Directors may take comfort from the fact that cases concerning these terms in the context of claims against directors are rare and instances where directors have been found to fall foul of the boundary rarer still. The terms are deployed to capture only the most egregious acts and failures and as such the scales of drafting are weighed heavily in favour of directors.
Bearing in mind that the articles of association of the fund are a contract between the investors inter se and the fund (but not with its directors), directors should take care to ensure that the protections contained in the articles are incorporated into the director’s own contract with the fund.
Ideally and for the avoidance of any doubt, those protections should be expressly incorporated into a services agreement although the Courts have recognised the incorporation of the articles where there is extraneous evidence that the director was appointed ‘on the footing’ of those articles – for example, an email chain where the director had specific regard to the existence of indemnity provisions in the articles before accepting the appointment.
Directors should also look to fill in any gaps in the articles through their own contracts with the fund. For example, a director services agreement may contain a mechanism for the upfront payment of the director’s legal costs, putting into practical effect the more general principle that an indemnified party is never called upon to put his hand into his own pocket. Service agreements can also be used to rectify deficiencies of a more fundamental nature – for example, where the indemnity may not cover all foreseeable loss or may not cover a director who leaves office.
This article was original published by Commercial Dispute Resolution.