Directors’ duties re zone of insolvency
It is important to note that even though the board of directors of a fund ordinarily delegate responsibility to manage the fund’s investments to investment managers, the board of directors cannot absolve themselves of responsibility entirely and remain under a duty, in any event, to supervise delegates (such as the investment manager).
Such duties are more prescient in times of financial distress given the judgment of the UK Supreme Court in BTI v Sequana on 5 October 2022 (which the Cayman Court would likely follow) in which the Supreme Court considered and clarified how directors’ duties ought to be applied when a company is in the zone of insolvency i.e. in financial distress.
As a starting point, and outside of insolvency, it is established law that a director’s fiduciary duty to act in good faith in the interests of the company is owed to the company as a whole and not to individual shareholders. However, once a company is insolvent the interests of creditors override those of the shareholders for the simple reason that shareholders no longer have an economic interest in the company. The Supreme Court provided helpful guidance as to when such a shift occurs and held that:
- Such a change of focus arises when the directors knew or should have known that the company was insolvent or bordering on insolvent or that an insolvent liquidation or administration was probable; and
- Any breaches of such duties by the directors cannot be ratified by a decision of the shareholders.
Applying the above principles in a fund context means that it is prudent for a director of a fund that is insolvent or bordering on insolvency to ensure that they become actively involved in monitoring the fund’s financial position and more stringently supervising any delegated powers.
As soon as the directors assess that the fund is in financial distress (and note the objective element of the test at A. above), the directors must start to consider and, subject to the financial position of the fund, perhaps prioritise creditors’ interests over shareholders’ interests. Practically speaking this means that the directors must ensure that the creditors’ (including redeemed but unpaid investors’, see blog 1 here) positions do not worsen by, for example, incurring further debt in circumstances where such debt cannot be repaid. It is a fine balancing act for directors in difficult circumstances, particularly given that the directors’ actions will likely be scrutinised post the event and it is therefore important that directors seek timely advice from experienced insolvency experts to assist and ensure all decisions are commercially justified and well documented. Failure to do so may give rise to personal liability against the directors.