Sedgwick’s Offshore Professional Risks practice offers a unique and global perspective on professional risk. As the only law firm in the world with offices in the key insurance jurisdictions of Bermuda, London and the U.S., Sedgwick offers unique perspectives and solutions for carriers operating in these and various offshore jurisdictions, including the British Virgin Islands, the Cayman Islands, the Channel Islands, and the Isle of Man.
In coordination with of our Professional Liability Seminar in London in June featuring attorneys Eric Scheiner, Karen Morrish and Alex Potts, we are pleased to present this digest highlighting various issues in offshore professional risks. We discuss offshore trustees, offshore directors, offshore hedge fund litigation and the US Foreign Account Tax Compliance Act. Please contact any of the team members for more information on these issues or if you have other questions related to professional liability.
Can Offshore Trustees Still Get Out of Jail Free Under the Rule in Hastings-Bass?
Over the past 15 years, offshore trustees have made a number of successful applications to courts in the Cayman Islands, Bermuda, Jersey, Guernsey, and the Isle of Man under “the rule in Hastings-Bass”, and other statutory restructuring provisions such as section 47 of Bermuda’s Trustee Act 1975 and section 48 of the Cayman Islands’ Trusts Law (2011 Revision), with a view to setting aside transactions effected by the trustees which subsequently had unexpected tax consequences, either for the trustees or for the trust’s beneficiaries.
These kinds of applications were described as “a magical morning after pill for trustees suffering post-transaction remorse”, and they were unusual because of the fact that relief could be granted to trustees so as to re-write history and eradicate unwanted tax liabilities, when no such relief would have been granted to individuals or companies who held assets in their own right. Indeed, these applications were also of considerable benefit to professional indemnity insurers of offshore trustees and their professional advisers, since they substantially reduced the risk that a professional negligence or breach of trust claim would be asserted against the trustees or their professional advisors (any such claim being limited to the modest mitigation cost of the Hastings-Bass application rather than the unexpected tax liability).
In March 2011, the English Court of Appeal decided in Pitt v Holt, Futter v Futter  EWCA Civ 197 that English common law had taken a wrong turn over the past 25 years, and considerably restricted the scope of ‘the rule in Hastings-Bass’. The English Court of Appeal held that before the Court could exercise a discretionary jurisdiction to set aside a transaction, it was necessary for the trustee to plead and establish that it had itself acted in breach of fiduciary duty, by failing to take or follow any professional advice: something which would be very rare in practice, and very unattractive for a trustee to have to admit.
In May 2013, the United Kingdom’s Supreme Court confirmed that the Court of Appeal had been correct to restrict the scope of “the rule in Hastings-Bass”, as a matter of English law: Futter v HMRC, Pitt v HMRC  UKSC 26. Although the offshore courts are ordinarily persuaded by, and follow, decisions of the Supreme Court, they are not technically bound by them (only by decisions of the Privy Council). Despite the Supreme Court decision being a unanimous decision of seven Supreme Court judges (and therefore highly persuasive), there is still a reasonable argument that the commercial, legal, and tax landscape of each of the offshore jurisdictions is sufficiently different to the landscape in England and Wales so as to justify continued reliance by offshore trustees and courts on the “rule in Hastings-Bass” as it existed before the English Court of Appeal and Supreme Court’s judgments. It is also possible that the offshore jurisdictions will each interpret or amend their domestic trusts legislation so as to expressly provide for such relief being made available to offshore trustees. Indeed, Jersey has already prepared draft legislation to that effect.
Another ray of hope for offshore trustees, and their insurers, is that the Supreme Court preserved the power of the court to set aside transactions and transfers on the grounds of mistake, where the transaction in question has unforeseen consequences. Although relief might still be available for mistakes relating to tax, the Supreme Court pointed out that in cases of “artificial tax avoidance, the court might think it right to refuse relief”.
For the time being, at least, offshore trustees might still be able to get out of jail free, but it may not be quite as easy as it was.
Claims Against Trustees and Settlement From Trust Assets
Insurers of professional trustees often face claims handling issues that are unique in the professional indemnity market.
In the context of third-party claims against trustees, one of these issues arises from the presence of an alternative source of indemnity in the form of the trustee’s right (by virtue of the trust deed and/or statute) to deploy trust assets in settlement of third-party claims and to be indemnified out of the trust assets against defence costs and third-party liabilities, subject to the sanction of the court. Typically, the insurer’s indemnity obligation under the policy will be triggered only when the trust assets have been exhausted. As such, just as an excess insurer will take account of the nature of underlying insurance, the amount and accessibility of trust assets to satisfy a trustee’s right of indemnity can be critical to a trustee’s insurer’s exposure.
The trustee’s ability to deploy trust assets in settlement of a third-party claim is often vulnerable to challenge by beneficiaries who want to see trust assets preserved for their own benefit (to the trustee’s and its insurer’s detriment). Beneficiaries often seek to argue that the trustee should resist or defend the third-party claim, either on jurisdictional grounds or on the merits. Since the trustee’s liability to third parties is personal to the trustee, beneficiaries often assert that a trustee’s decision to settle a substantial third party claim is motivated by the trustee’s self-interest in limiting its own personal liability and reputational damage, rather than any concern on the part of the trustee to act in the best interest of the beneficiaries.
This dynamic is illustrated by a recent decision of the Jersey Royal Court, Capita Trustees Limited v RS and others (6 February 2013). The trustee (Capita) wished to enter into a settlement with various third parties that would exhaust the assets of the trust and sought court approval to do so. Although the trustee was empowered to enter into the settlement without court approval, it accepted that it was under a conflict of interest and therefore surrendered its discretion to the court. The court agreed that the trustee was conflicted and accepted the surrender of discretion. As such, the court had to place itself in the position of the trustee and act in the best interest of the beneficiaries in deciding whether to sanction payment by the trustee of the entire trust assets to the third-party claimants in settlement of the claims.
Queen’s Counsel were called as experts on behalf of the trustee and one of the two beneficiaries. Although they agreed that the amount of the proposed settlement payment was justified on the basis of the merits and the trustee’s potential exposure, the beneficiary nevertheless contended that the court should not approve the settlement, arguing (among other matters) that the court would not be acting in the best interests of the beneficiaries by permitting the entire exhaustion of the trust’s assets, including the sale of a home occupied by the beneficiaries. Despite the beneficiary’s objections, the court approved the settlement. The court held that the trustee’s duty to act in the best interest of beneficiaries did not mean that the trustee was obliged to fight a hopeless claim. The court stated that a trustee is under a duty to act reasonably and if satisfied that a claim is due, he should pay it.
Although it is not apparent whether insurance was involved, the Capita case provides some comfort to insurers that, in appropriate cases, the court will sanction the deployment of the entire trust assets towards the settlement of third-party claims, with insurer’s exposure thus limited to any liability in excess of the trust assets.
Disclosure of Trust Documents to Beneficiaries
The first sign of a breach of trust claim by a beneficiary against a trustee is often in the form of a request by the beneficiary for access to trust information. Such requests may arise from particular concerns over poorly-performing trust assets or may be in the nature of a gratuitous fishing exercise by a disgruntled beneficiary.
Courts in many offshore jurisdictions follow the Privy Council’s decision in Schmidt v Rosewood Trust Ltd  2 AC 709, which confirmed that applications for disclosure of trust information invoke the inherent jurisdiction of the court and are to be determined as a matter of the court’s discretion on the facts of the particular case.
A recent decision of the Bermuda court has considered whether it is possible to narrow or even to exclude the court’s discretion by the settlor including a specific information control clause in the trust deed. In Re A Trust  SC (Bda) 16 Civ, two beneficiaries of a Bermuda trust, with assets in the region of US$1 billion, had been engaged in what the judge described as a “humungous family row”. The principal beneficiary was also appointed as “protector” of the trust with powers that included a power, in the form of an information control clause, to request information from the trustees and veto its disclosure by the trustee to the beneficiaries. However, the protector was unwilling to exercise her power to assist the other beneficiary with whom she was in dispute. The disgruntled beneficiary then applied to the Supreme Court of Bermuda seeking an order for disclosure of information from the trustee.
Bermuda’s Chief Justice Kawaley held that the information control clause was legally valid as it did not eliminate the trustee’s irreducible obligation to account and nor did it seek to oust the inherent jurisdiction of the court to order disclosure. However, he concluded that the court should “show deference for the terms of the trust deed” and should only intervene if an order for disclosure could be shown to be “necessary” on the facts of the case.
On the facts of the case before him, the chief justice was prepared to order disclosure to the applicant beneficiary. In doing so, he relied on the protector’s conflict of interest as both beneficiary and protector, noting that the two parties had been engaged in “open warfare” and that the protector had manifested a “blanket refusal” to allow the trustee to supply any trust documents to the other beneficiary, including documents as basic as the trust deed. The case is subject to an appeal, although an application for a stay of the disclosure order pending determination of the appeal has been refused.
From a trustee’s operational and risk management perspective, there are obvious benefits to a trustee in having an information control clauses inserted into a trust deed by a settlor, so as to control a beneficiary’s access to trust information and avoid having to give disclosure in response to the most frivolous requests. However, trustees should note that such clauses cannot be used as a tool to lock out beneficiaries from all internal trust affairs and ultimately the court will retain jurisdiction to order disclosure in appropriate cases. Given the reputational and costs risks associated with an unsuccessful challenge to a beneficiary’s application for disclosure of trust information, as well as the impact that the outcome of such a disclosure application can have on any substantive claim that follows, trustees would be well advised to take legal advice and consider notifying their insurers as soon as possible of any controversial requests for disclosure of trust information. Insurers, in turn, should take a considerable interest in such requests, given the kinds of claims that tend to follow.
In Re A Trust, perhaps mindful of the trustee’s concern that the beneficiary was planning an attack on the trust, the judge was at least willing to order that safeguards should be put in place to maintain confidentiality and to limit the use to which any such information or documents could be put, without further leave of the court.
The Duties of Offshore Nominee Directors
The use of nominee directors is common in many offshore jurisdictions that follow English common law. A nominee director is specifically appointed by a shareholder of a company to represent its interests, and to act in accordance with its wishes and instructions so far as possible.
The main reasons cited for the use of nominee directors of companies in offshore jurisdictions include representation of specific stakeholder interests on the board of directors; privacy and confidentiality; satisfaction of local residency requirements; and ability to perform routine corporate services in the country of incorporation, such as bank account opening, regulatory filings, and instruction of local attorneys.
In practice, nominee directors often find themselves subject to substantial conflicts of interest, given their separate duties to the company, their regulatory obligations (including AML reporting obligations), and their duties to the person that appointed them (who is normally thought of as their “client” and pays their fees). Some nominee directors also suffer from the difficulty that they offer their services to many different companies at the same time1. Since these conflicts of interest are not easy to manage in practice (especially as companies approach insolvency), the use of nominee directors has been the subject of considerable criticism by the courts. For example, in Dalemont v Senatorov  JRC 061A, the Jersey Royal Court recently criticised a nominee director of an offshore company who did not know the identity of the company’s shareholder, and knew nothing of the company’s assets, documents, and corporate transactions. This was “a state of affairs consistent with the worst criticisms that might be made of the offshore financial services industry”.
In the decision of Ciban Management Corporation v Citco (BVI) Limited, 27 November 2012, by contrast, the BVI High Court took a generous approach to the standard of care to be expected of nominee directors and corporate service providers in the BVI. Mr. Justice Bannister held that, under BVI law, the duty and standard of care to be expected of a professional, corporate nominee director, appointed by the company’s sole shareholder, was limited due to the circumstances of appointment.
The court held that it was implicit in the relationship between the sole beneficial owner and the nominee director that the nominee director was neither required nor expected to exercise any independent executive functions or discretion, nor to review the wisdom of commercial transactions. The nominee director was intended and engaged to be nothing more than the execution instrument through which the sole beneficial owner’s will could be given legal effect. This division of responsibility between the sole beneficial owner of a company and its board was described as a “perfectly lawful arrangement” under BVI law. The court was concerned that if it imposed a higher standard of care on nominee directors, BVI corporate service providers would no longer be able to provide companies and director services at a modest and competitive cost.
The standard of care to be expected of offshore nominee and non-executive directors and corporate service providers is an area that is likely to be the subject of further debate in litigation. It is also the focus of a variety of regulatory measures currently being considered in offshore jurisdictions such as Bermuda and the Cayman Islands. For the time being, however, the Ciban Management decision (subject to any appeal) should provide some measure of comfort to liability insurers of corporate service providers in the BVI and similar offshore jurisdictions, especially when compared with the $111 million judgment of the Grand Court of the Cayman Islands against the former non-executive directors of Weavering Macro Fixed Income Fund Limited (also pending appeal).
Offshore Hedge Fund Litigation
Hedge funds incorporated in offshore jurisdictions such as Bermuda, the British Virgin Islands, the Cayman Islands, Guernsey and Jersey have faced substantial legal challenges and litigation as a result of the global financial crisis.
Of most direct interest to D&O and E&O insurers, of course, are the claims by hedge funds, or their liquidators and receivers, against their former directors, officers, and service providers. These claims have included:
Hedge fund claims against directors and officers for damages or compensation for breach of their fiduciary duties, breach of contract, breach of their statutory obligations, negligence, and dishonesty or fraud;
Hedge fund claims against investment managers for damages for breach of their fiduciary duties, breach of contract, negligence, and dishonesty or fraud;
Hedge fund claims against investment managers for restitution, seeking to clawback mistaken overpayments made in respect of their management or performance fees;
Hedge fund claims against administrators, auditors, custodians, prime brokers, and attorneys for breach of contract, breach of their statutory obligations, and negligence; and
Hedge fund claims against investment managers, administrators, NAV calculation agents, and auditors, for errors and omissions in the valuation of their assets, the calculation of NAV statements, and the detection and reporting of financial irregularities or breaches of investment restrictions.
Also of interest to D&O and E&O insurers are the claims made directly by investors against hedge funds, and hedge fund directors, officers and service providers (often asserted speculatively in US courts rather than in the offshore courts), including:
Investor claims for repayment of the subscription price, on grounds of misrepresentation, mistake, or failure of consideration;
Investor claims for payment of a debt or damages, on grounds that a redemption request, or a compulsory redemption, has not been satisfied; and
Investor claims for damages for loss of profits, on grounds of misrepresentation, breach of contract, negligence, breach of fiduciary duty, dishonesty or fraud.
Finally, there has been important hedge fund litigation arising in the liquidation and regulatory context, including:
Disputes as to whether or not a hedge fund should be put into liquidation, and, if so, when and under whose control;
Disputes about the recovery of the fund’s documents and assets;
Disputes about the timing and method of liquidation and distribution of the fund’s assets, including reserve and payment for any indemnity claims by directors, officers, and service providers; and
Disputes over the status of segregated assets under “segregated account” and “protected cell” legislation.
As a result, the past five years have seen a very substantial body of “offshore hedge fund” case law build up, addressing a wide variety of distressed fund and liability issues. Although some consensus has started to emerge between the various offshore courts (all guided by the Privy Council), on certain legal issues such as the rights of redeeming and non-redeeming investors, the legal effect of side letters, the legal effect of “synthetic side pockets” and payments “in kind”, and the meaning, scope and effect of indemnities in favour of directors, officers, and service providers, the case law also shows how important it is for all parties, including insurers (especially when claims handling):
to consider the particular facts and circumstances of each particular risk and claim;
to review the wording of the fund’s constitutional documents, offering documents and contractual agreements in question;
to understand the details of the applicable governing law and legislative provisions, and the procedural rules of each offshore jurisdiction; and
to take a strategic and cross-jurisdictional view of the range of claims that might be asserted by or against the various entities involved in a distressed fund.
Reform of Hedge Fund Corporate Governance
Reform of hedge fund corporate governance in Cayman remains in limbo following opposition by the local professional services community to proposals to publicise or limit the number of appointments fund directors hold.
Like most jurisdictions, Cayman responded to calls for reform by the Financial Stability Board and the Basel Committee on Banking Supervision following diagnoses that corporate governance failures lay at the root of the financial crisis.
The spotlight on Cayman was more intense after the eye-watering award of $111 million in damages against directors of Weavering Capital’s Macro Fixed Income Fund for wilful misconduct in office.
The Cayman Islands Monetary Authority (CIMA) already prescribes principles of good corporate governance. However, these do not apply to the vast majority of funds, which accept only high net worth or institutional investors. Transparency and disclosure by these funds have been hitherto preferred to regulatory approval and supervision of them and their directors.
CIMA also already regulates local professional fund directors. But for a vast number of fund directors, there are no requirements as to residence, qualifications, experience. Nor is there any limit on number of appointments that directors (professional or otherwise) may accept.
In January 2013, CIMA proposed to:
reinforce governance principles with oversight functions, and extend them to all funds
establish a public database of relevant information about funds and directors, including number of appointments held by directors
extend the regime applying to professional service providers to any person holding remunerated directorships on six or more boards.
Local professionals welcome further principles-based regulation and transparency. However, they think publication of number of appointments endangers their business model, in which a limited number of individuals discharge, with the support of substantial teams of assistants, duties under a large number of board appointments.
One provider has sought judicial review of the proposals. This has prevented CIMA from proceeding with the reforms, for now. It is not clear how this will develop, although the lack of any decision by CIMA yet makes judicial review look precipitate. CIMA has not ruled out a cap on number of appointments, in lieu of publication. But this is just as unpopular. Perhaps like other jurisdictions it will instead require proof on a case by case basis that the proposed director won’t be prevented from discharging his duties by extraneous commitments.
The US Foreign Account Tax Compliance Act (FATCA)
The US Foreign Account Tax Compliance Act (FATCA) came into force on 1 January 2013, and the final implementation Regulations were published on 17 January 2013. Although FATCA is a US law, it imposes extensive tax reporting obligations on non-US Foreign Financial Institutions (FFIs), including offshore entities that:
(1) accept deposits (such as offshore banks, custodians, and, in certain circumstances, offshore insurance companies),
(2) hold financial assets for others (such as offshore trustees and trust companies), and
(3) engage in the trade of securities, partnership interests, commodities or other derivatives (such as offshore hedge funds, private equity funds, and SPVs used for securitisation).
FATCA is designed to detect and discourage offshore tax evasion by US taxpayers, and tasks FFIs with investigating and automatically reporting on the offshore financial affairs of US citizens and residents. In certain circumstances, it also requires the FFI to withhold tax payable to the IRS.
FATCA will be implemented domestically through a bilateral Intergovernmental Agreement (IGA). In common with the UK, the British Virgin Islands, the Cayman Islands, Jersey, Guernsey, and the Isle of Man have each chosen to adopt a Model 1 or Model 1B IGA, which require local FFIs to report only to their local tax authorities, which in turn make reports to the IRS.
Bermuda has chosen to adopt a Model 2 IGA, which requires local FFIs to register with the IRS and to submit annual returns directly to the agency. FFIs will be obliged to withhold a 30 percent tax on any US sourced income received by a US Account holder who refuses to cooperate with submitting information to the IRS. Comparable agreements are likely to be entered into between the various offshore jurisdictions and the UK, requiring similar disclosures to HMRC.
The types of income that can attract the withholding tax include dividend payments, premium payments, proceeds from the sale of US securities, wages and other forms of compensation, profits and interest on deposits in US and non-US banks. FFIs will also be required to withhold 30 percent of any US sourced income that would ordinarily be payable to another FFI if that entity is non-FATCA compliant.
Reporting guidance issued by the IRS suggests that FFIs must adopt procedures to identify and document “US Accounts”, which include depository accounts, custodial accounts and any non-publicly traded debt or equity interests in an FFI, that are held by a specified “US Person” or “US Owned Foreign Entity”.
Under a Model 2 IGA the costs and risks associated with obtaining client consent before disclosing financial data to the IRS, and in investigating whether non-US counterparties are FATCA compliant, are borne by the FFI.
Liability insurers should take a keen interest in their offshore insureds’ FATCA compliance initiatives and standards. They should also consider their insureds’ standard terms and conditions on FATCA-related issues, and the steps being taken to secure client consent to disclosure of financial information to the IRS.
It can only be a matter of time before FATCA-related complaints start to be made against offshore entities. Complaints are likely to be made, on the one hand, by clients who assert that the FFI has wrongfully reported confidential financial information or wrongfully withheld client money, or by local or foreign tax authorities.
Assuming that FATCA achieves its stated purpose, it seems inevitable that there will be an increased number of onshore tax investigations into undisclosed offshore accounts and tax avoidance schemes. This, in turn, is likely to lead to yet more claims being asserted against trustees, tax advisors and the promoters of offshore financial services.
For now, it would not be surprising if some form of judicial review challenge is pursued in one of the offshore jurisdictions against the legality of FATCA and domestic enabling legislation. There has already been significant litigation in Bermuda and the Cayman Islands regarding the enforcement of foreign tax requests made under current Tax Information Exchange Agreements.