Even the casual observer will note the troubling convergence between the billion-dollar claim for damages by the liquidators of two Bear Stearns Cayman Islands-based investment funds, which continues to work its way through the New York courts, and the judgment handed down by the Cayman Grand Court in August in favour of the plaintiff to the tune of some $111m (£69m) in Weavering Macro Fixed Income Fund Limited (In liquidation) v Stefan Peterson & Hans Ekstrom.
Both cases involve Cayman investment funds with independent directors on their boards. Those directors are in one case alleged and in the other found to have failed to discharge their duties as directors in broadly similar ways.
The claims turn, to a greater or lesser degree, on a lack of involvement and supervision with regard to directors’ duties and a disregard, whether couched in terms of negligence or willful default, of proper investigation by the directors into the inflated value of each fund and a series of unauthorised related party transactions.
There is no new law in these cases and an in-depth analysis of the well-enshrined common law duties of directors is not attempted here. These cases are about the application of those duties. Some of the underlying issues that were unearthed are important, not only in the Cayman context, but also across the professional spectrum. These are issues of form over substance, conflict of interest and the relevant standards of directors in the performance of their duties.
It is trite law that directors of a company owe duties to the company of which they should be aware. What these cases highlight is the extent to which directors cannot simply rely on the judgement or influence of other people, such as arrangers or principals.
Weavering makes it clear that directors are not expected to have unlimited knowledge and expertise across all sectors, and that it is perfectly acceptable that directors delegate and engage external advisers to assist them, provided the boundaries of responsibility are defined clearly and the directors do not lose sight of their duty to keep themselves informed and supervise those delegates.
It is common for offshore directors to sit on the boards of numerous companies – often hundreds. This is possible where companies are largely on autopilot once the mechanics have been put into place, and is more true of structured finance transactions than mutual and hedge funds simply because more of the financial engineering can be approved in the former case at inception.
The vast majority of offshore directors have adequate professional qualifications and should be able to assess commercial situations with the right supporting knowledge obtained from those to whom they delegate. That, though, does not seem to have been true in either Weavering or the Bear Stearns case, with directors signing off minutes when it is questionable whether they knew what was really happening.
There is speculation as to whether the problem boils down to a question of fees and whether the directors would have acted differently if their fee levels had been higher. The correlation between fees and level of responsibility assumed by the directors was raised in Weavering, as it was in the famous Jersey trust case of Abdel Rahman v Chase Bank (CI) Trust Company Ltd & Five Ors (1991).
In Weavering the judge rebutted firmly the suggestion that the level of responsibility assumed was diminished because the directors were not taking a fee for their role and countered that the lack of fees was rather indicative of the fact that the directors never, in fact, intended to perform their duties in any meaningful way.
Is the same true for the Bears Stearns offshore directors? Would they have performed better had their fees been higher? It is difficult to say, but what the Bear Stearns case brings to the fore is that fees and issues of conflict are closely linked.
In Weavering the failure to perform resulted from personal conflict considerations and possibly indifference. The Bear Stearns situation seems only slightly different – those funds had apparently independent offshore directors on their boards coupled with an independent trustee holding voting shares, but both service providers were related to the offshore law firm.
It is perhaps inevitable that offshore service providers for a client such as Bear Stearns with their eye on valuable future instructions will have regard to the fresh carrot both for themselves and their affiliated law firm, while still gnawing through the first.
The affiliations that have been established over the years between offshore law firms and their management services arms may be detrimental to interested parties, as the Bear Stearns case demonstrates. A truly independent set of directors or fiduciaries would not face the same internal level of conflict or feel the inevitable pressure associated with being a business conduit to the affiliated law firm. The same position of conflict is evident from the point of view of the affiliated law firm.
We must not lose sight of the fact that the demands of principals are often onerous and have militated in favour of the ’one-stop shop’. But in these cases the directors were all asked to perform in short order, often without proper explanation. The cases highlight the fact that the ’head in the sand’ approach will not work. Directors must ask the right questions and gather a meaningful amount of information to which they apply real discretion in order to avoid a sham situation arising.
Unless directors and service providers are able to be truly independent and act without conflict, and until the boundaries of responsibility, expectation and conflict are satisfactorily addressed, the pressure will mount and the types of collapse evidenced by these cases will continue even in highly regulated jurisdictions such as Cayman.
The jury is still out on whether the one-stop shop model best serves the interests of the client and their investors.
This article was first published in The Lawyer on 7 November 2011.