October 2011

LEGAL EASE: Directors found guilty

M_FeargrieveMatthew Feargrieve, partner and team leader of the Funds and Investment Services practice in the Zurich office of Appleby tells us about a new regulation for hedge funds directors.

In August, the Grand Court of the Cayman Islands delivered what is being hailed as a seminal judgment on the subject of directors’ duties in the context of offshore hedge funds.

In Weavering Macro Fixed Income Fund Limited (in liquidation) v Peterson and Ekstrom, the Court found a fund’s independent directors guilty of wilful default in the discharge of their duties, and ordered them to pay damages to the fund’s liquidators in the sum of $111 million (€82.12 million), representing the losses suffered by the fund which were caused by their default.

The fund’s investment manager arranged the appointment of his younger brother and elderly stepfather to serve as the fund’s directors merely to meet minimum legal requirements rather than to form a real board of directors. Over a period of years they did nothing beyond signing large numbers of documents at the manager’s request, even signing fictitious minutes of two board meetings which never took place.

This semblance of corporate governance allowed the manager to fraudulently inflate the fund’s net asset value (Nav) by booking false interest rate swap transactions to disguise substantial losses. By the time this scheme was discovered, millions had been wrongly paid out to investors by way of redemptions based on Navs, which were artificially inflated to the tune of $111 million. In these circumstances, it was easy for the court to find the directors guilty of wilful default.

This case gave the trial judge a platform from which to make statements of principle about the duties of hedge fund directors. These statements are important because they adapt long-standing legal principles concerning the duties of non-executive directors of conventional companies for the unique structure of a hedge fund. These are:

• The Cayman Islands investment fund 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”. Directors must act in the best interests of the fund which, in this context, means its potential investors.
• While independent directors rarely have the technical expertise and experience to be able to monitor sophisticated investment strategies and trading techniques in a hands-on manner, they are expected to satisfy themselves that the fund is complying with investment restrictions set out in its prospectus and to acquire a proper understanding of the financial results of the investment and trading activity, without which they would not be in a position to perform an overall supervisory role.
• It is their duty to satisfy themselves that the fund’s various service providers are performing their functions in accordance with the terms of their respective contracts and that no managerial and/or administrative functions which ought to be performed are left undone.
• Independent directors must do more than simply react to problems that may be brought to their attention by the fund’s other service providers. They must apply their minds and exercise an independent judgment in respect of all matters falling within the scope of their supervisory responsibilities.
• Reviews of financial accounts must be conducted in an inquisitorial manner, the directors making appropriate enquiries of the administrator and auditor.
• Independent directors are expected to be able to read a balance sheet and have a basic understanding of the audit process. If they accept a responsibility for a fund’s financial statements (by issuing management representation letters and signing the financial statements), it is their duty to exercise an independent judgment in satisfying themselves that the financial statements present fairly the fund’s financial condition.

This case represents the first rather than the last word on hedge fund directors’ duties. The judgment may still be subject to appeal, and no other court has yet had an opportunity to comment on its findings or apply its statements of general principle. In particular, the question of what constitutes a “high level of supervision” will be subjected to more rigorous scrutiny.

©2011 funds europe