The Isle of Man’s appeal court has delivered its judgment in CFSL Limited v UK Secured Finance Fund PLC (in Liquidation) and UKSFF Subsidiary Limited, an appeal brought by CFSL Limited (CFSL) against a finding earlier in the year that it had acted in breach of contract and failed to exercise reasonable skill and care in its management of UK Secured Finance Fund PLC (Fund) and its subsidiary UKSFF Subsidiary Limited (Subsidiary).
The Fund was a “qualifying fund” established under the Collective Investment Schemes Act 2008 (CISA) and the Collective Investment Schemes (Qualifying Fund) Regulations 2010 (Regulations). Its investment objective was to make interest bearing loans at the recommendation of the Fund’s investment advisor. CFSL was the Fund’s manager and was authorised to approve the loans made by the Fund. Multiple loans were made which did not comply with the investment objective set out in the Fund’s offering memorandum (OM) and were then not repaid. The Fund went into liquidation in 2015, and the liquidators are now seeking to recover damages from CFSL on behalf of the Fund and its Subsidiary.
The appeal focussed on the duties owed by CFSL to the Fund, both under the management agreement and under the CISA and the Regulations; whether there had been a breach of those duties; and whether liability for breaches could be excluded.
The management agreement between CFSL and the Fund contained clauses limiting CFSL’s liability for any losses except those arising from wilful breach of duty or gross negligence of CFSL.
The Court found that these were unenforceable because of the statutory prohibition set out at section 8 of the CISA, which provides that:
“Any provision of any document constituting an authorised scheme or an international scheme is void in so far as it purports to exempt the promoter, governing body, manager, administrator, trustee, fiduciary custodian or custodian from liability for any failure to exercise due care and diligence in the discharge of that person’s functions in respect of the scheme.”
The Court rejected CFSL’s argument that the clauses complied with the CISA by retaining liability in instances of its gross negligence, and instead interpreted section 8 of the CISA as prohibiting exclusion clauses “in so far as they seek exclusion of liability for any failure, not only if they purport to exclude liability for all failures”.
This aspect of the judgment is significant for governing bodies and functionaries of Isle of Man funds as it makes clear that section 8 of the CISA invalidates any clause which seeks to limit or exclude liability for loss to a fund caused by any failure to exercise due care and diligence, however minor.
Section 8 of the CISA applies to any document constituting an Isle of Man fund (other than an exempt scheme), and the CISA defines the documents that constitute a fund broadly. Among others, administration agreements, management agreements, custody agreements, service contracts and fund constitutional documents all fall within its scope so may be impacted. Functionaries should also review their insurance policies to ensure there are no gaps in cover.
Importance of complying with the OM
The Court stressed the importance of complying with offering documents, noting that “Qualifying Funds are required to be operated in accordance with their offering documents, it being fundamental that collective schemes actually operate in the manner that is promoted to investors”.
The Court found that CFSL owed a duty to the Fund to seek to ensure that the loans it made complied with the OM. This finding may be fact specific and distinguishable in other circumstances, given CFSL’s close involvement in the loan process under the terms of the management agreement.
The Court also found that it was not within the power of the Fund’s directors to authorise CFSL to deviate from procedures described in the OM, endorsing the judgment at first instance that “both the directors and CFSL were bound to follow the OM and any direction of the directors to CFSL not to follow the OM would have been legally unlawful”. Rather, if the Fund’s governing body wished to change the parameters for the loans, they should have done so through a lawful process (ie. revising the OM in accordance with the procedure set out in the OM).
Duties of Managers – don’t rely on other people
CFSL challenged the Fund’s wide interpretation of the scope of CFSL’s duties, pointing to the roles and duties of the Fund’s board and investment manager and highlighting that the management agreement gave the board overall supervision and control.
The Court found that different parties could have overlapping duties; that duties set out in the management agreement should be read as consistent with duties under the CISA and the Regulations; and that the roles of other agents did not negate the manager’s own duty of care, noting that “such total separation of agents’ roles, and subordination of the manager’s role to mere functionary, would be a recipe for no proper management at all, or at least enable or risk crucial aspects ‘falling through the cracks’.”
CFSL also failed to convince the Court that, through quarterly board meetings, the Fund’s directors had ratified the loans and relieved CFSL of any liability. The Court noted that the directors had breached their duties to the Fund and acted contrary to its articles of association; that CFSL knew that the Fund was not being operated in accordance with the OM as it should have been; and that there was no basis for CFSL to believe that the Fund’s directors could lawfully override that requirement. In fact, insofar as CFSL knew or ought to have known that any directions or instructions from the Fund’s directors were unlawful, the Court held that it had a positive obligation not to follow them. In summary, CFSL was an agent of the Fund, just as the Fund’s directors were, and neither were entitled to rely on the other’s wrongdoing.
The Court also noted that, whilst other parties were also to blame for the Fund’s failure, this did not avoid CFSL’s own liability.
This is a stark reminder not to overly rely on the governing body or other functionaries or advisors to a fund.
Duties of Managers – reporting to the FSA
The Court also considered CFSL’s obligation to report non-compliance with the OM to the Isle of Man Financial Services Authority (FSA). This was set out in the management agreement and also arose under the CISA and the Regulations.
The Court agreed with the judgment at first instance, which noted that CFSL had filed annual compliance declarations with the FSA confirming, amongst other things, that the Fund was being managed and operated in accordance with the OM, and found that CFSL had breached its duties by failing to notify the FSA that the Fund was not in fact complying with its OM.
Lessons to learn and actions to take
This case raises a number of key reminders for all those within the Isle of Man funds industry, notably of:
- regulatory requirements to ensure that a fund is managed and operated in accordance with its constitutional documents and offering document;
- regulatory requirements to keep offering documents up to date;
- duties to act with reasonable skill and care;
- the importance of acting in accordance with your own duties, rather than relying on other people; and
- regulatory requirements to report non-compliance with offering documents.
We would encourage all directors and functionaries of Isle of Man funds within the remit of section 8 of the CISA to review the terms of their agreements and limitations on liability. Insurance policies should also be reviewed to ensure that any gaps in cover are plugged.