The Cayman islands was doing so well lately in refurbishing its image. With the recent Cayman Islands Corporate Governance Survey, and director licensing initiatives it looked as though investors were finally about to have some real form of director oversight, and perhaps dare we say it even material accountability?
Well it seems this was too good to be true. At least that’s what’s the Cayman Islands court system effectively stated with its most recent decision in the Weavering case. As a quick recap, in this case two directors of the Weavering Macro Fixed Income Fund were originally determined by a Cayman Court to have been negligent in the oversight of the fund.
This was a problem for the directors because the fund was later found to effectively be fraud, and the firm’s founder Magnus Peterson was recently sentenced to 13 years in jail. Furthermore, by being found negligent the directors were on the hook for a judgment of approximately $100 million USD.
As expected, they appealed the ruling and the Cayman Court agreed with them. Without delving too much into the legal technicalities in this case (i.e. – what constitutes willful negligence versus default), one thing is clear from this decision – this latest development in the case represents a major step backwards for hedge fund governance.
Aren’t Directors Protected By Indemnification Clauses?
To be clear, issues of negligence and associated terms, in particular willful negligence as it applies to the directors in the Weavering case, are related to the broader area of director indemnification.
Despite minor difference in indemnification standards among different jurisdictions, the standard of negligence is effectively set by the hedge fund themselves in their offering documents. An indemnification at a standard of “willful negligence” is quite common in the hedge fund industry. However, in this case the Cayman Court of Appeals disagreed with the UK Court, which found the directors to be negligent. Further deviations the interpretation of the standard of terms such as willful negligence between jurisdictions will likely further develop going forward only complicating the issue even more.
Practically, this most recent Cayman Court decision effectively outlines that the directors of Weavering were not “willfully negligent.” Therefore, it is perhaps even more concerning that this sets a legal precedent for not only Cayman funds, but also potentially sets the evidentiary bar quite high to show a case of actual negligence for funds outside of the Caymans.
From the perspective of investors it further widens the gap between the promise of what directors should be doing to implement rigorous fund oversight and the realities of their lack of liability for failing to do so.
Interestingly in an interview for his new book, Hedge Fund Governance: Evaluating Oversight, Independence and Conflicts (Academic Press, 2014), Corgentum Consulting Managing Partner, Jason Scharfman, interviewed a representative of the Cayman Islands Monetary Authority (CIMA) about the impact on governance and director liability of the Weavering decision before it was overturned.
While CIMA indicated that they would effectively be responsible for monitoring direct competence and capabilities under the licensing laws. They also stressed the importance of investors conducting their own extensive due diligence into fund directors liabilities, potential conflicts and the actual level of oversight and authority in place. Clearly with this decision the Cayman Court of Appeals is echoing CIMA’s sentiment that investors, not the financial regulators or courts, are the ones who will be financial penalized for conducting insufficient upfront and ongoing due diligence on fund governance issues and directors.
Would AIFMD Have Saved the Day?
What about new AIFMD laws would they have helped in this case to prevent a future escape from liability? Unfortunately, a depositary under AIFMD would not necessarily have been held liable for Weavering losses, as depositaries in general do not take on strict liability for assessing the risks of Alternative Investment Managers (“AIFs”). Complicating matters even further would be issues of shared liability in situations where there may be multiple appointed depositaries. This is an example of the reasons investors should be conscious of these potential gaps in liability when designing their due diligence programs to include a review of the role of depositaries.
What About The Other Service Providers Besides Directors?
Due to the fact that directors effectively delegate a majority of their day to day oversight of a fund to both the fund managers themselves and other service providers such as auditors and administrators, there is enough liability to go around.
Unfortunately, cases like these demonstrate that there is a bit of a game of hot potato that goes on where everyone passes the responsibility for liability from one service provider (i.e. – the directors) to another (i.e. – the auditors or administrators). With each service provider pointing the finger at each other it can be sometimes difficult to assign exact liability and investors are unfortunately often left unable to recoup their losses from service providers.
Evaluating the governance structures in place at hedge funds is an ongoing challenge. Simply analyzing the role of the directors is not enough. Rather than limit our focus to a single area, as part of Corgentum’s operational due diligence research, we
partner with investors to assist in evaluating the overall governance risk and control frameworks in place throughout the entire fund complex.