Cayman Islands Law Issues in U.S. Investment Fund Litigation

Litigation in U.S. courts that involve Cayman investment funds, their shareholders, directors and service providers, in particular at the suit of shareholders and liquidators, is on the increase. This article gives an overview of some of the more important of those issues that are most frequently encountered—directors’ duties, shareholders’ derivative claims, reflective loss and indemnity and exculpation provisions for directors and service providers. In this article, the focus is on corporate Funds, although the same principles will apply generally to Cayman companies. Different considerations will apply in the case of partnerships.

Directors’ Duties: Where They Come from and What They Are
The legal system in the Cayman Islands is founded on the English system and has at its basis a foundation of English statutes, English common law and equity.

Common Law
Directors’ duties in the Cayman Islands have developed over the years by closely following the position in England. [1] In addition to the common law, certain duties are found in Cayman Islands statutes, as well as in the Fund’s constitutional documents (principally its Memorandum and Articles of Association). The duties set out below are provided as a guide and are not exhaustive.

Common Law Fiduciary Duties
Directors are in a fiduciary position towards their fund. Directorship is an office, which gives rise to a relationship of trust and confidence, and accordingly to an obligation of loyalty. This over-arching duty contains a number of specific duties:

• act in good faith; [2]
• not to make a profit from his or her position as director;
• not to place himself or herself in a position where his or her duty and interest may conflict; and
• not to act for his or her own benefit or for the benefit of a third person without the informed consent of his or her principal (i.e., the fund). [3]

These duties are proscriptive in nature: the common law casts them fundamentally in terms of what the director must not do; generally, they do not tell him what he ought to do. [4] These duties are frequently curtailed by the terms of the Articles of Association of a fund. [5]

Common Law: Other Duties and Torts
Duty to exercise skill and care. It is the duty of a director to act in what he or she considers to be the best interests of the fund. [6] The precise nature of the duty will vary according to the size and business of the fund and the experience or skills that a director held as having in support of his or her appointment. However, broadly stated, the standard of care owed by a director of a fund at common law is that of a reasonably diligent person having both:

• the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as are carried out by that director in relation to the fund (an objective element); and
• the general knowledge, skill and experience that that director has (a subjective element). [7]

Negligent misstatement and deceit. Director liability for torts may exist in addition to or independently of the fund since if a director commits a tort while performing his or her role as a director, he or she will on general principles, be personally liable for the tort. Disgruntled investors and their advisers are therefore increasingly scrutinizing the terms of offering memoranda to see if, as part of the circumstances surrounding a distressed fund, they provide a foundation for an action in the torts of negligent misstatement or deceit (fraudulent misrepresentation).

Negligent misstatement. The tort of negligent misstatement can be utilized by a shareholder but it is not usually a weapon of first choice. Assuming the obstacles created by the principle of reflective loss [8] can be overcome (which will by no means be easy), a plaintiff shareholder must show that on the particular facts, a director “assumed responsibility” toward the shareholder which created a “special relationship”; that the director owed a duty of care to that shareholder when he or she carelessly made a false statement to the shareholder; and also that the shareholder relied on the statement in, for example, purchasing the shares in the fund (or conversely, not selling his or her shares) and thereby suffered loss. Each of these elements can be difficult to establish, particularly the existence of a duty of care. Directors should nevertheless be careful to ensure that they review any draft offering memoranda to check that all material statements of fact or opinion are accurate, and also be mindful of what is said in any communications they have with shareholders outside of the offering memoranda, particularly given that most offering memoranda include a statement confirming that they have been approved by the directors. [9]

Deceit. In order to recover damages for the tort of deceit, it is necessary for the shareholder to prove affirmatively that a director made an untrue statement of fact fraudulently. That is to say, either that the false statement was made intentionally or that it was made recklessly as to whether or not it was true (or perhaps simply not caring whether it was true or false). [10]

In general, directors in an action for deceit will escape liability if they can prove that they did believe the fact stated, even though their belief was not based on reasonable grounds, for if they truly believed the statement, fraud is negated. [11] However, if the basis for the belief was so unreasonable as to make it impossible to hold that the defendant honestly believed that the statement was true, a director may still be found liable. Reflecting the different policy considerations at play, it is of note that unlike a claim for negligent misstatement, there is no need for the shareholder to establish an “assumption of responsibility” by the director (as opposed to the Fund) toward the shareholder. [12] As Lord Hoffman has pointed out, “no one can escape liability for his fraud by saying “I wish to make it clear that I am committing this fraud on behalf of someone else and I am not personally liable.” [13]

Accessory liability in tort. Unlike in the U.S., for example, as a matter of Cayman Islands law there is no authority that shows a person can be civilly liable as an “accessory” for the tortious acts of another (whether the relevant tort arises under the common law or statute) unless he or she is actually jointly responsible for the tort or has procured the act constituting the tort. However, third parties can face personal liabilities for comparable liabilities such as knowing receipt (which can arise where a third party receives property as a consequence of a director’s breach of fiduciary duty) or dishonest assistance (where a third party dishonestly assists in a breach of fiduciary duty).

Statute: Obligations on Directors under Cayman Islands Legislation
In addition to the common law, various obligations are imposed on directors/funds in the Cayman Islands under the following principal statutes: the Companies Law, Mutual Funds Law, Penal Code and Proceeds of Crime Law. As these obligations are concerned with civil and criminal penalties, with any action ordinarily taken in the Cayman Islands by the Cayman Islands Monetary Authority, these statutory duties are not considered in any detail in this article. However, the following obligations are of particular note since their existence may well inform the broader context in which a Court will approach the issue of whether a director has adhered to his common law duties discussed above. In particular:

• The need for diligence in preparing offering memoranda is plain from the statutory obligation in the Mutual Funds Law, which requires “an offering document in respect of equity in a mutual fund shall (a) describe the equity interests in all material respects; and (b) contain such other information as is necessary to enable a prospective investor in the mutual fund to make an informed decision as to whether or not to subscribe for or purchase equity interests.” [14]This is without prejudice to the common law duties of disclosure in relation to the content of offering memoranda.
• The Penal Code provides that “whoever [including a director], with intent to deceive members or creditors of [a Fund] about its affairs, prohibits or concurs in publishing a written statement or account which to his knowledge is or may be misleading, false or deceptive in a material particular, is guilty of an offence and liable to imprisonment for seven years.” [15]
• Unlike the position under English law, there is no statutory offence of wrongful trading [16] in the Cayman Islands (albeit if this occurs, it is likely that a claim for breach of fiduciary duty may be brought instead). However, the Companies Law does make specific provision for offences relating to certain conduct in the 12-month period prior to the commencement of a winding up of a fund by its directors or officers with the intent to defraud the fund’s creditors or contributories. A person convicted of such an offence is liable to a fine and imprisonment for five years. [17] Separate offences concerning directors or officers of a fund are contained within the Companies Law relating to misconduct in the course of a winding up [18] and the making of material omissions in any statement relating to a fund’s affairs with intent to defraud the fund’s creditors or contributories. [19] Upon conviction, directors, officers or professional service providers of the fund may be liable for a fine of up to $25,000 and/or to imprisonment for a term of five years. [20]

Constitutional Documents
A fund’s Memorandum and Articles of Association are also a source of directors’ obligations. A director must act in accordance with (and not outside) the powers contained within the fund’s constitutional documents, [21] and his powers and duties set out in the Articles of Association, and any service contract between him and the fund. Directors must ensure that they are familiar, in particular, with the fund’s Articles of Association and understand how its provisions—which form the basis of the bargain as between shareholders inter se, [22] and as between shareholders and the fund—operate. Directors and other officers of the fund will understandably wish to be aware of the scope of any indemnity and/or exculpation provisions within the Articles, an issue discussed in section 2.2 below.

To Whom are Directors’ Duties Owed?
Directors’ fiduciary and common law duties are, absent special circumstances, owed to the fund in respect of which they are appointed, and not to the fund’s individual creditors or shareholders. A fund’s directors are not, by virtue only of being directors, in a fiduciary or special relationship with the fund’s individual shareholders. This long-established principle, [23] while not ruling out direct actions by a fund’s shareholders (for the fact that a director owes fiduciary and common law duties to the fund does not preclude additional duties co-existing [24]), has made such shareholder grievances difficult to formulate as actionable claims against the directors personally. In addition to the difficulty posed by the general absence of a direct duty owed by a director to a fund’s shareholder, the cumulative effect of the following three aspects of the legal framework surrounding claims in this area can place considerable limits on the ability of shareholders and funds to take direct action against directors and/or service providers: (1) the principle of reflective loss, (2) the so-called rule in Foss v Harbottle, [25]and (3) exculpation and indemnity clauses.

Reflective loss. The principle of reflective loss dictates that where a fund suffers loss caused by a breach of duty owed to it, only the fund may sue in respect of that loss. No action lies at the suit of the shareholder suing in that capacity to make good a loss in the value of his shareholding, where it merely reflects the loss suffered by the fund. [26] As a result, a personal claim may only be brought by a shareholder where he or she can demonstrate that a breach of duty owed to him or her personally, and significantly, personal loss separate and distinct from that suffered by the fund. [27] To allow otherwise would entail either double recovery by the shareholder and the fund at the expense of the director or allow the shareholder to recover at the expense of the fund and its creditors and other shareholders. The wide scope of the reflective loss principle was reinforced by comments made by Lord Millett while sitting in the Hong Kong Court of Final Appeal. [28] Lord Millett disapproved an earlier decision of the English Court of Appeal, [29] which had suggested that the bar on recovery by a shareholder posed by the principle of reflective loss does not apply to a shareholder suing a director where, in breach of his contract with the company and its shareholders, the director “steals” the whole of the company’s business, with the intention that the company should be so denuded of funds that it cannot pursue its remedy against him or her, and who gives effect to that intention by an application for security for costs (against the company), which his or her own breach of contract has made it impossible for the company to provide. In Lord Millett’s view, no such exception existed for it would produce precisely the result on recoverability that he had identified as unacceptable in a previous House of Lords decision. [30] The principle of reflective loss, broadly stated, is therefore considered to remain intact in the Cayman Islands. This is one of the reasons why a petition for the winding up of the fund by the Court may prove to be a more suitable procedure for an aggrieved shareholder.

The rule in Foss v. Harbottle and derivative actions. A derivative claim is a claim by a shareholder of a fund in respect of a cause of action vested in the fund itself (not the shareholder) and seeking relief on behalf of the fund, typically involving allegations of negligence or breach of fiduciary or other duty. A derivative action is an exception to the principle in Foss v. Harbottle, which provides that where a wrong has been done to a fund, prima facie, the only proper plaintiff is the fund itself and that an action by a shareholder claiming relief for the fund is not available. The plaintiff may only bring a derivative action (so-called because it is based on a right “derived” from the fund) if it falls within the exceptions to the rule in Foss v. Harbottle. [31]

The most significant of these exceptions arises when the wrong has been done to a fund in circumstances where the wrongdoers are in control of the fund and are preventing action being taken by the fund. To ensure that the law provides a remedy for the wronged minority, it permits an individual shareholder to bring an action on behalf of the fund. Of course, where a fund is in receivership or official liquidation, the receivers or the liquidators, and not those alleged to have committed the wrongdoing, will be in control of the fund. [32] The exception to the Foss v. Harbottle rule would not apply in such circumstances; it would be for the receivers or the liquidators—not a disgruntled shareholder—to commence any action (although, in practice, a shareholder would likely apply to the court seeking a direction from the court that a particular action be brought by the receivers or liquidators, or, if appropriate, that the receiver or liquidator be removed and replaced). [33]

Furthermore, as an additional layer of protection for funds and directors against vexatious claims, a shareholder must apply for permission from the Grand Court to continue a derivative action. [34] This requires the court to be satisfied that the plaintiff has a prima facie case both in relation to the merits of the claim on behalf of the fund, and that the alleged wrongdoing has been perpetrated by the majority, who were in a position to prevent the fund from pursuing the claim. [35] In addition, where the plaintiff shareholder, as is usual, seeks to be indemnified by the fund for the cost of bringing the derivative action, the shareholder must also satisfy the court that, even if the fund does have such a prima face case, a hypothetical independent board of directors of the fund acting reasonably would have brought and proceeded with the case. [36]

Exculpation and indemnity clauses. Indemnity and/or exculpation clauses in favor of directors are generally to be found in a fund’s Articles of Association. The precise ambit of these clauses will vary depending on the particular words used; however, they can be widely drafted and in the Cayman Islands, can be effective to exclude liability for all liabilities except fraud—either “actual fraud” (in the sense of knowing dishonesty or reckless disregard of duty) or, more controversially, “equitable fraud” (a looser concept which includes breach of fiduciary duty). [37] Even if there is no exculpation clause, the existence of an indemnity clause will itself indirectly, by circularity of action, have the effect of an exculpation clause, insofar as claims are brought by the fund (including derivatively) since there is no cause of action against a person whom the plaintiff is liable to indemnify in respect of the same matter. [38]

Investment advisers and investment managers. There is scant authority on the issue of whether investment advisers and investment managers owe fiduciary duties to the funds they advise or whose assets they manage, or to the shareholders of those funds and the scope of those duties. In relation to investment managers, the English Court of Appeal has commented that “[i]t would be unusual for an investment manager acquiring and managing a portfolio of investments under a formal management agreement not to owe duties…of a fiduciary nature to the other party in the agreement.” [39]

The relationship of agency will generally import fiduciary duties, and it is easier to spell out a case for the existence of fiduciary duties in the case of an investment manager, who has control over the fund’s assets, than an investment advisor, who merely advises. Common-law duties, in tort and contract, would of course arise in the case of both.

The extent of any fiduciary or other duties of the investment manager or investment adviser will be determined principally by reference to the terms of any investment management or investment advisory agreement. In this regard, investment managers and advisers should be aware of incorporation into the law of the Cayman Islands of the English law concept of “shadow directors”—this concept applies to a person in accordance with whose directions or instructions the directors of a fund are accustomed to act. [40] Depending on the factual circumstances and the investment manager’s relationship with a fund, for example, the investment manager could be construed as being a “shadow director,” with the consequence that he may be held to owe the same fiduciary and common law duties as a de jure director, [41] as well as exposure to certain statutory offences under the Companies Law. [42]

However, whatever the ambit of an investment advisor’s or investment manager’s duties, those duties will be owed to the fund, and absent special circumstances, not to the fund’s shareholders, although a derivative claim may lie at the instance of a shareholder. Since a fund incorporated as a company is a legal personality in its own right, distinct from its shareholders, the fund owns the assets of the fund, including any rights of action accrued in its favor; those assets do not belong to the shareholder.

Conclusion
In the current economic climate, those suffering losses in distressed funds are likely to continue to seek redress in whatever they perceive to be the most advantageous jurisdiction. There appears to be an increasing tendency in U.S. proceedings for shareholders to launch proceedings relating to Cayman Funds without any or sufficient regard to applicable Cayman law principles of duty, reflective loss, derivative claims and exculpation clauses. Apart from any difficulties, there may be in the subsequent enforcement of overseas judgments in respect of such claims in the Cayman Islands, the immediate consequence is that a number appear to be struck out on motions to dismiss the claim, where a closer enquiry into applicable Cayman law issues would have led to a different formulation of the claim, and to the defeat of such a motion.