Jeremy Walton and Andrew Bolton outline the liquidation strategies available in relation to Cayman Islands funds
Legal manoeuvrings in the aftermath of recent fund collapses such as Bear Stearns, Basis Yield Alpha and Absolute Capital have generated much controversy and debate. With over 75% of the world's hedge funds domiciled in the Cayman Islands, and an increasing number of them in distress, it pays to understand the options that Cayman law offers to interested parties when NAVs start to plummet. Depending on the characteristics of a fund and the reasons for its difficulties, successful liquidation strategies can be developed from an informed choice between the various options outlined below.
Reorganizations/Schemes Of Arrangement
Typically, the management of a distressed fund will want the opportunity to trade the fund out of its difficulties. They will seek to avoid a run on the fund, with heavy levels of redemptions forcing the realization of assets at unfavourable prices, which further depress the value of the fund. By the time a fund is in trouble, if its offering document and articles of association do not allow the directors to impose an adequate gate limiting redemptions to a specified level or otherwise lock in classes of investor for defined periods, it may be too late to change them. Investors who redeemed but cannot be paid may not be bound by a restructuring agreed by the remaining shareholders.
A formal scheme of arrangement, sanctioned by court order, may provide an alternative. To be approved, a scheme must have been supported by a majority in number representing at least 75% by value of the groups affected (whether shareholders or creditors or particular classes of them) at a meeting duly convened for this purpose. The court must still be satisfied that it is fair, and may still not approve a scheme that achieves the requisite votes if it considers the result unfairly prejudicial to an opposing minority.
Voluntary Liquidation
In many cases, the best solution is simply to wind up the fund and distribute the assets. Voluntary liquidation provides a quick out-of-court procedure for achieving this at relatively insignificant cost. It requires a special resolution of the fund's shareholders, but usually management will hold the only voting shares, so this will be easily achievable. Any person (such as a director) can act as the voluntary liquidator. However, winding up a hedge fund where there is any controversy surrounding its collapse usually requires the appointment of an independent professional insolvency practitioner: a liquidator's primary duty is to maximize asset recoveries for the benefit of creditors, which will often require investigating claims against management and related parties who may have been responsible for the insolvency.
Voluntary liquidation may not be appropriate if the liquidators would have to collect assets or obtain other assistance from courts in other jurisdictions, since their appointment and powers will not be readily recognized elsewhere; or if the fund is exposed to claims by third parties which are liable to further diminish its assets before they can be distributed to creditors pari passu. The process requires acquiescence by creditors and shareholders: they can challenge the voluntary liquidation or alternatively petition to bring the liquidation under the supervision of the court.
Court Supervised Liquidation
A voluntary liquidation may at any time be converted by court order into a winding up 'under the supervision of the court' (as distinct from 'by the court' in the case of compulsory liquidation, dealt with below). This is a 'half-way house' between voluntary and compulsory liquidation that does not exist in the English insolvency regime. It has the advantage of giving the liquidators greater powers and the ability to be recognized and gain assistance from foreign courts, as well as imposing a moratorium on claims by third parties. An order to bring a winding up under the supervision of the court has the effect of making the process effectively equivalent to compulsory liquidation. The same liquidators can (and often will, unless there is a good reason to replace them) be appointed official liquidators by the court. Bringing a voluntary liquidation under court supervision can therefore be used to some extent to pre-empt creditors' petitions seeking compulsory liquidation.
Compulsory Liquidation
A traditional investment fund's only creditors at any given time are usually redeemed investors who have not received their redemption proceeds and service providers whose fees are unpaid. By contrast, the nature of hedge funds is such that they commonly have very significant creditors, because of their use of derivative instruments and leverage to magnify returns. The position of creditors is therefore pivotal in the liquidation of a hedge fund. Those creditors are often secured, and Cayman law will respect their rights: allowing them to exercise self-help remedies afforded by their contractual arrangements and giving them priority in a winding up over unsecured creditors.
Even if the assets of the fund are insufficient to allow for any return to equity holders, it is often in the interests of creditors (particularly secured creditors) to petition for the compulsory liquidation of a fund, rather than permitting the continuation of any workout process aimed at recouping value for investors which risks further losses. It is therefore common for leverage counterparties and other creditors to petition as soon as there is a default in payment to them. By doing so they hope to force payment of their debts, either through being paid off by the fund (to avoid being wound up) or through the liquidation process itself.
Petitioning to wind up the fund is often an alternative to simply suing it in regular court proceedings. There are a number of advantages and disadvantages in pursuing a liquidation strategy rather than a conventional debt or damages action; which is the right course will depend on the nature and extent of a fund's difficulties and the terms under which its creditor is owed his debt.
One advantage of putting the fund into the hands of a court-appointed liquidator is that he has broad powers to recoup assets and restore value to the fund, including by means of claims against third parties. Of course the results must be shared with other creditors, but so too are the costs; and distribution will be in accordance with the usual order of priorities, so that secured creditors have prior rights up to the value of their security, and only when all secured and unsecured creditors are fully paid will anything be available for shareholders.
Because of this system of priorities, shareholders in an insolvent fund may not be allowed to petition for its winding up, on the basis that they have no financial interest in the outcome. On the other hand, redeemed investors may qualify as creditors and can petition. Some interesting questions await determination by the Cayman courts concerning whether and when such investors become creditors for the purpose of acquiring standing to pursue this strategy.
Alternative Remedies For Investors
Investors who hold shares in insolvent funds may feel that they have nothing to gain from any kind of liquidation process, since they stand behind secured and unsecured creditors in the order of priorities. Their principal interest will be looking to recover compensation from those responsible for the insolvency, whether through claims by the liquidator on behalf of the fund or (more rarely) by direct shareholder action. Investors holding 20% of the participating shares may petition the Cayman court for the appointment of an Inspector to investigate the fund's affairs: he has broad powers (like a liquidator) to examine books and records and to question directors. His findings are recorded in a report to the court, which is made available to the petitioners and may be used as evidence in any subsequent proceedings. Generally a little-used remedy, this is potentially of great utility for shareholders in insolvent funds.
Conclusion
These liquidation options are mutually exclusive and may be invoked in opposition to each other: parties have differing interests and a choice that best serves one party may be detrimental to another. While the Cayman court will, if necessary, have the final say on what is the fairest process for all concerned, considerable advantage can be obtained by those who understand their options and are ready to deploy their own optimal strategy.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
