Directors not to be Judged with the Benefit of Hindsight

The recent Guernsey judgment Carlyle Capital Corp (“CCC”) v Conway and Others [2017] Guernsey Royal Court provides very useful guidance to directors as to what is expected of them by the courts.

Facts:

CCC was a Guernsey-registered closed-ended sophisticated investor fund, investing mainly in residential mortgage-backed securities issued by US Government sponsored entities known as Fannie Mae and Freddie Mac. Its seven directors were very experienced banking and financial market experts. In 2007, with huge volatility in the sub-prime markets, CCC saw an opportunity and it purchased USD 23 bn worth of securities. The purchases were made by borrowings, leveraged at 37 times CCC’s issued share capital. However, as the financial crisis deepened in late 2007 and into 2008, margin calls on the borrowings heavily ramped up. Initially, CCC survived by borrowing to meet the calls from Carlyle group companies. However, following the collapse in the US of Bear Stearns in March 2008 and the turmoil across financial markets that followed, CCC collapsed.  In 2010, the CCC liquidators launched proceedings in 2010, claiming c. USD 2 bn in losses against, inter alia, the seven directors on the basis the directors had acted irresponsibly in not recommending that CCC sell down the securities, raise additional capital or conduct an orderly wind-down from the end of July 2007 onwards.

Royal Court Findings:

The liquidators alleged numerous breaches of fiduciary duties and of the duties of skill and care against the directors. The Court firmly rejected all allegations, finding that, based on their knowledge at the time and without the benefit of hindsight, the directors’ actions were “perfectly rational, prudent, proper and reasonable, in context… an appropriate response to market events as they unfolded and affected CCC…..on the evidence they were actually the safest and best course for CCC to adopt in the circumstances.”. 

The judgment provides useful guidance to directors as to what is expected of them by the courts.

Good Faith

The Court found this to be a subjective duty to act in what the director bona fide believes are the best interests of the company. This is to be assessed on the evidence. The ultimate question is: was the decision one within the range of reasonable decisions by a hypothetical director? If the director failed to consider actually the best interests of the company, he would not be acting in good faith.

Duty to Exercise Independent Judgement

The Plaintiffs made considerable criticism of the non-executive directors in failing to be independent.  The Court considered it is important for a director not to fetter his or her discretion to make a decision in the exercise of the director’s powers and not to abrogate responsibility. However, delegation is permissible.

The Court stated:

"broad principle behind this duty is that the company is entitled to the benefit of an actual and freely arrived at decision or judgement from those who are its directors.  A director will therefore breach this duty if he merely does what he is told by others for whatever reasons, or acquiesces without question or consideration in what he is asked to do or told by others."

"a duty to exercise an independent judgement does not mean a duty to act entirely alone, nor to act without taking into account any views expressed or even decisions which are made by his fellow director.  A director must exercise his own judgement according to his own assessment of the facts but where, for example, a director does not possess a particular expertise but is aware that one of his fellow directors does, there is nothing in this duty which obliges the first director either to make a decision without ascertaining the views of the expert director or without having regard to them, or to make himself a sufficient expert in the area that he can assess the opinions of the expert director from a position of expertise."

Duty to Avoid Conflicts of Interest

It was alleged that some of the directors were employed within the Carlyle group and the decisions post 2007, that this gave rise to a conflict of interest and decisions were then arrived at that were not in CCC’s best interests.  There is no rule that a director may only be a director of one company. The Court made clear that an objective test is to be applied to such situations: was there a real, sensible possibility of conflict? The Court considered these allegations to be theoretical only. 

Interests of Creditors

It is well established that upon becoming insolvent, the directors must consider the interests of creditors and prospective creditors. CCC was in financial difficulty but not insolvent. So, when does the duty to consider creditors arise?  The Court held that the duty arises:

 “when it can be seen that decisions about the company’s actions could prejudice the creditors’ prospects of recovering their debts in a potential liquidation.”

Proper Purpose Duty

The question to be asked is whether the director’s decision or action (even if honest, in good faith and without personal interest) was valid and legally effective? The Court explained that this requires directors (i) to consider the nature of the power granted, (ii) the purpose for which it was granted, (iii) to understand the substantial purpose for which it was granted and (iv) decide that it was proper to take the decision or action in question.

Duty of Skill and Care

The Court explained the test as follows:-

"that of a reasonably diligent person having both (a) the general knowledge skill and experience that may reasonably be expected of a person carrying out the same functions as those of the relevant director with regard to the company and (b) the actual knowledge skill and experience of that director…. a combined objective and subjective test, …the subjective element is capable of raising, but not lowering, the standards to be expected of an individual director."

On the subjective element, the Court stated that this refers to the special skills that the individual brings to the board for the benefit of the company. Finding the directors had not breached their duty of skill and care, the Court stated:-

"the test for whether there has been a breach of duty is a high one.  It is that a director will be in breach of his duty of skill and care only if the court is satisfied that no reasonably diligent director with the material degree of knowledge, skill and expertise could have acted in the way in which the particular defendant director did act.  The point is that the court must be satisfied that the decision complained of went beyond a mere error of commercial judgment."

Overview

Jersey and Guernsey companies laws are very similar. The extensive judgment provides very useful guidance. It is said that in assessing a director’s culpability, not just in the criminal but in civil and regulatory matters, a director will inevitably be judged by his actions and conduct against the standards required of him. The Guernsey Royal Court has thankfully drawn a firm ‘line in the sand’ in criticising directors’ conduct in the context of an unprecedented event as in the case of the financial meltdown from 2007 onwards. However, it took seven years of expensive litigation.