Directors' duties in the wake of Carlyle
22 December 2017
On 4 September 2017 Lieutenant Bailiff Hazel Marshall QC handed down her highly anticipated judgment in Carlyle Capital Corporation Limited (in Liquidation) and others v Conway and others.
Carlyle Capital Corporation Limited was a Guernsey closed-ended investment fund set up in 2006 which was heavily invested in the US residential mortgage-backed securities market.
Carlyle suffered two liquidity crises in the financial crash of 2007/2008 and was ultimately forced into compulsory liquidation after the US housing market collapsed. The liquidators subsequently commenced claims against all the former directors, the asset and investment manager and two promoters including for breach of fiduciary duties, gross negligence and wrongful trading. They alleged the directors ought to have sold off a substantial portion of Carlyle's asset portfolio to save the company from collapse and that their failure to do so caused significant financial loss. All 187 claims against the directors were dismissed.
As a case, Carlyle was quite remarkable by any measure and an example of Guernsey's capability as a jurisdiction to conduct world class litigation. The judgment itself has not broken new ground, though, or delivered ground-breaking legal precedent. It does, however, provide a comprehensive review and outline of the Guernsey law concerning directors' duties.
Carlyle in numbers
- Litigation lasting 7 years
- Claims over USD 2 billion
- 252 pages of claims met with over 570 pages of defences
- 107 volumes of evidence
- 4,872 identified documents
- 14 factual and 16 expert witnesses
- Six month trial with 67 sitting days
- 525 page judgment
It is trite law that directors of Guernsey companies owe duties to the companies they serve. In her judgment, LB Marshall QC provided detailed guidance through a rigorous and comprehensive statement of the nature and scope of those duties, namely to:
- act bona fide in the best interests of the company;
- act for proper purposes / not to act for collateral or improper purposes;
- exercise independent judgment;
- avoid conflicts of interest; and
- exercise reasonable skill and care.
The first four duties are classed as fiduciary in nature as they are founded on obligations of good faith, loyalty and honesty. The final duty is different in that it is concerned primarily with competence. The Court in Carlyle for the first time expressly endorsed this distinction as forming part of Guernsey law, thereby following jurisdictions such as England and Wales and Jersey (where it is codified in statute (see Article 74(1) of the Companies (Jersey) Law, 1991)).
Duty to act bona fide in the best interests of the company
The core fiduciary duty of a director is one of loyalty. A director must act honestly in what he or she considers are the best interests of the company. The duty is therefore subjectively defined and the Court in Carlyle confirmed that there is no duty at law to make an objectively right decision (often with the benefit of hindsight). A course of action may still be in the best interests of a company even where it happens also to benefit, or even be in the best interests of, a parent or associated company.
To fulfil this duty, a director must show that the best interests of the company were central to the decision or action taken. The consideration given to the company’s interests must be "more than a mere token" and not "merely cursory" or incidental.
So what happens if a director fails to take account of the interests of the company at all? LB Marshall QC held that the correct approach in such a situation was to examine whether the decision or action was nevertheless within the "range of decisions" that a properly loyal and competent hypothetical director could reasonably have made in all the circumstances. This entails an element of objectivity in circumstances where a director fails wholly or partially to consider the best interests of the company and where the director ought not to be able to hide behind his or her subjective bona fides.
Duty to act for proper purposes / not to act for collateral or improper purposes
This fiduciary duty is concerned with whether a director has acted for a proper purpose within his or her powers. It is a matter of law or construction of the Memorandum and Articles of the company and contains an objective element. It follows that, even if a director acted honestly and in good faith, he may be found in breach of duty if he violated the purposes of a company as set out in its Memorandum and Articles or statute.
Duty to exercise independent judgment
Directors must not fetter their discretion in the exercise of their powers nor must they abrogate their responsibilities. A director must not acquiesce unquestioningly. However, it does not mean a duty to act alone or without taking account of views expressed or even endorsing decisions made by fellow directors (especially where such director possesses particular relevant expertise). At a minimum, directors must keep themselves sufficiently informed of the company's affairs in order to make their own decisions.
Duty to avoid conflicts of interest
Directors are under a fiduciary duty to avoid actual or possible conflicts between their duties to the company and their other duties (e.g. to another principal) or their own personal interests. However, a director should not be suspected not to be performing (or to be incapable of performing) his or her duty to the company simply because that director is also appointed by or associated with another company.
There is no rule in English law (and unlikely to be one in Guernsey) that a person may not be a director of more than one company, even where they are in competition; subject to the following provisos:
- a director who is in that position has to arrange his affairs to enable him to discharge his duties to both companies as loyally as if each were his only principal; and
- any such conflict may be properly avoided by the director making full disclosure of this position and obtaining the consent of each principal to his also acting for the other.
Duty of care and skill
A director is required to exercise a reasonable standard of care and skill in the performance of his functions. In Carlyle, the Court held that the relevant standard will be assessed against both objective and subjective elements, taking account of:
- the knowledge, skill and experience expected of a reasonable person performing the director's role or function in relation to the company (objective test); and
- the knowledge, skill and experience the particular director actually has (subjective test).
A director will thus be held to a higher standard of competence in light of any enhanced skills, knowledge or expertise the director actually has. But a higher standard will not be imposed simply because a director is voting rather than non-voting on the board.
Contrary to the fiduciary duties, where a director falls short of the standard of care and skill expected of him, it will be no defence to say that he or she acted honestly and loyally. Nevertheless, the bar for breach is a high one such that the decision or act complained of must be one to which no reasonably competent director could have come and must go "beyond a mere error of judgment".
Some factors that the Court will look at to evaluate the level of diligence and skill reasonably expected of a director include:
- the role of the director in the governance and management structure of the company;
- any particular skill the director holds himself out as having;
- the level of remuneration of the director; and
- the size of the company and nature of the business.
De facto directors
In Carlyle, the liquidators sought to fix the investment manager and two Carlyle entities with liability for breach of directors' duties. A de facto director acts only as a director in fact but not as of right. A de facto director does not assume responsibility for the totality of a company's acts or activities and may only be held liable for specific (offending) directorial acts actually performed.
To qualify as such a "directorial act" four criteria must be satisfied:
- an act carried out on behalf of the company that only a de iure director of that company could perform;
- an act carried out by the corporate entity sought to be fixed with liability (i.e. by a human actor who is an empowered officer or duly authorised agent of that entity and for that purpose);
- an act that the relevant actor could not legitimately be doing in a capacity other than that of a director of the company; and
- in order to give rise to liability - an act that was in some way causative of the damage to the company of which complaint is made.
Shadow directors do not act as directors themselves but rather procure the acts of actual directors who are mere conduits. Directors' duties only attach to shadow directors in very limited circumstances, namely where the term is actually used in statute or is to be treated as if it had been used. Pursuant to the Companies (Guernsey) Law, 2008 this includes wrongful trading and provisions that require a director to make disclosure of interests.
To fix an entity with liability as a shadow director for breach of duties it must be shown that:
- the actual directors were accustomed to act in accordance with directions or instructions given by the (individual or corporate) shadow director;
- the actual directors would include a relevant voting majority of the board of directors; and
- there is a series of acts or obedience; one instance will not generally be enough but "in an appropriate case, relatively minimal evidence of previous biddability might well suffice".
Carlyle had three independent directors who were non-executive but with voting rights. The NEDs were faced with allegations that they did no more than acquiesce to the requests of the executive directors. The Court rejected those allegations and provided useful guidance on the function and duties of NEDs:
- the role of NEDs is to provide "dispassionate oversight" and a "detached level of scrutiny" to decisions of the board;
- it is not for NEDs to second-guess and re-deliberate operational management decisions but they must actively participate in the decision-making process;
- NEDs are expected to exercise a high degree of general business acumen but need not exhibit a similar degree of detailed knowledge or expertise as an executive director; and
- their independence is determined by reference to whether the NED has in fact fulfilled his or her duties as a director of the company and not based on any specified criterion.
The Court in Carlyle confirms that there is no general duty to hold board meetings. They are a means to an end, namely to arrive at a considered decision on relevant aspects of the company's business. However, the impact of holding or not holding a meeting may be considered as part of the overall factual matrix going to any alleged breach of duty.
The Court also touched on the purpose and practice of minute taking. Meeting minutes are intended to provide an accurate and sufficient record of the business at a meeting. They must record the formal elements of the business (i.e. proceedings) of the meeting but not necessarily the content of discussions. Where those discussions have been omitted, it is not in and of itself indicative of a breach of duty. The Court cautioned that board minutes ought to be amended only by those who were present at the meeting in order not to risk creating a false record.
Companies on the "brink of insolvency"
The Court in Carlyle considered the scope of directors' duties at a time when a company finds itself in serious financial difficulty. It is the first time that a Guernsey Court has clarified that a director's duty to act in the best interests of the company will extend to embrace the interests of creditors and prospective creditors when a company faces imminent insolvency.
Directors must therefore have proper regard for the interests of creditors (and give precedence to those interests where necessary) in recognition of the fact that the creditors will have priority of interest in the assets of the company over its shareholders in a subsequent winding up. Such extended duty would not arise, however, until the company is "on the brink of insolvency". That is, when it can be seen that decisions about the company’s actions could prejudice the creditors' prospects of recovering their debts in a potential insolvent liquidation.
It does not mean that the interests of creditors are paramount in the sense that the directors must act in the best interests of creditors alone. It also does not require immediate cessation of trade and realisation of the company's assets (often in a fire sale) if, for example, the directors honestly believe that trading on would provide the best chance of the creditors being paid in full rather than suffering losses.
- Directors owe the companies they serve a range of fiduciary duties, including a core duty to act honestly and in good faith in the best interests of the company (which will be subjectively assessed).
- Directors must exercise a standard of care and skill expected of a reasonable diligent director carrying on the functions and duties of that person in respect of the company and with an enhanced level of skill and expertise which that director actually has.
- The distinction between fiduciary duties and the duty of care has been expressly recognised as forming part of Guernsey law.
- Directors must have proper regard for the interests of creditors and potential creditors once a company is on 'the brink of insolvency'.
- De facto and shadow directors can be fixed with liability for breach of directors' duties only in a narrow set of circumstances.
- The role of NEDs is to provide oversight to decisions of the board from a more detached perspective, but it is not necessarily unreasonable for them to follow the guidance of their more expert co-directors.