The Grand Court of the Cayman Islands has handed down a decision which addresses not only the vexed question of the status of redeeming hedge fund investors but also the ability of a Cayman liquidator to resolve the issue of 'false profits' arising from a Ponzi scheme.

Herald Fund SPC (Herald) was one of the larger Madoff feeder funds and made headlines recently when it settled the competing claims between it and Irving Picard (the Trustee in Bankruptcy of the Madoff estate).

Primeo Fund was also a Madoff feeder fund; however, it invested a significant portion of its assets via Herald. In late 2008 Primeo submitted a request to Herald for the redemption of a large portion of its investment for the 1 December 2008 Redemption Day. However, on 11 December 2008, and before the redemption proceeds could be paid to Primeo, Madoff confessed to his criminal scheme and the directors of Herald suspended all redemptions from the fund the following day. Sometime later Herald went into liquidation. The question for the Cayman court to determine therefore was whether Primeo became a creditor of Herald in the amount of its redemption request and therefore ranks for a dividend in the liquidation ahead of the other unredeemed investors in the fund.

According to the ruling of Jones J, Primeo's submissions began with the proposition that the question as to when a company's shares are regarded as having been redeemed is answered by reference to the relevant provisions of its articles of association. Support for this proposition was found in the decision of the Privy Council in Culross Global SPC Limited v. Strategic Turnaround Partnership Limited 2000 (2) ClLR 364 and the parties agreed that the relevant shares were redeemed as of the 1 December 2008 Redemption Day. The second limb of Primeo's argument was that the part of s37 of the Companies Law (described by the Court as a comprehensive code relating to the issue and redemption of redeemable shares) which deals with the status of redeeming investors in a liquidation (s37(7)) did not apply in a scenario where the investor has already redeemed (i.e. the relevant redemption day has passed).

The Court looked at the provisions of s37(7) and found that the subsection applies only in a case in which a company's shares are "to be redeemed", for example on a fixed date, or in the case of shares which "are liable to be redeemed", for example, where "a valid redemption notice has been served but the steps required by the articles of association to be undertaken in order to complete the process of redemption have not been completed prior to the commencement of the liquidation". However, shares which have already been "redeemed" pursuant to the company's articles of association fall outside the section and are treated as ordinary creditor liabilities.

The import of this finding is that an investor who has 'redeemed' as set out above is no longer subject to the restrictions contained in s37(7) which are as follows:

1. If the redemption date falls after the commencement of the winding up the redeemer ranks as a shareholder and not as a creditor.

2. If the company was not solvent in the period from the redemption day to the winding up the redeemer ranks as a shareholder and not as a creditor.

3. If neither of the above provisos apply, the redeemer still ranks behind outside creditors but ahead of other shareholders in the winding up.

In finding that s37(7) does not apply to Primeo, and that it therefore ranks not behind but alongside outside creditors, the Grand Court would appear to have gone a step further than the the Privy Council in Strategic Turnaround where Lord Mance, while finding that the "redeemed" investor was a creditor, nevertheless stated that it was "a current creditor ranking behind outside creditors, but ahead of continuing members1".

It is clear, however, that Lord Mance's dictum in Strategic Turnaround, "in order to protect the shareholders whose shares are not to be redeemed, the terms and manner of the redemption must be set out in the company's articles" has found widespread support in the Cayman courts.

In Lansdowne Limited & Ors v Matador Investments Limited & Ors [2012 (2) CILR 81] Quin J relied on that statement in support of his finding that "provisions of the articles cannot be trumped by" conflicting side agreements. Indeed, it would appear that parts of the Companies Law may give way to those same provisions.

A separate point was also considered by the Grand Court in the same liquidation and between the same protagonists. It is a well-known aspect of Ponzi-scheme frauds that they are akin to a game of musical chairs – when the music stops investors who remain in the scheme are like the players without chairs: they lose out in favour of those who had already taken their money out. It is less well understood that iniquities can arise even among the losers – primarily between those who invested early and those who invested later. The early investors will have their nominal investment swollen by months or years of so-called 'false profits'. The US Courts have adopted what is known as the 'net equity' model to deal with this issue so that when distributions do become available to the investors the 'false profit' element is taken out and the early investors do not profit at the expense of others.

The Additional Liquidator of Herald sought initial guidance as to whether he is empowered to rectify the register of members of Herald in order to ultimately produce a 'net equity' type distribution among the remaining investors. The Court has found that the power to rectify a company's register of members post-liquidation is exercisable in the Cayman Islands (pursuant to s112 of the Companies Law) "in circumstances where it is necessary to rectify the register in order to do justice amongst those recorded as shareholders as at the commencement of the liquidation". Precisely how that is to work in practice was not determined and is likely to be the subject of further rulings. It is not yet known whether the Herald decisions will be appealed.


1 [2010 (2) CILR 364] at para 42

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