Originally published in the Cayman Financial Review

Encountering illiquidity

During the course of the fund industry's slow yet sure recovery from the fallout of the global credit crisis, it has become increasingly apparent that prudently structured investment funds of all types should strongly consider including provisions in their constitutional documentation contemplating a "soft wind down".

In the turbulent times post 2008, advisers to Cayman Islands funds were increasingly asked to come up with solutions for funds which, whilst solvent and continuing to trade, had encountered liquidity issues with their underlying investments and needed to put in place an ad hoc regime to manage cash flow and account for investor redemptions. The documentation relating to such funds often lacked provisions specifically contemplating this scenario and such funds were therefore placed in a precarious position when they received substantial redemption requests from investors.

Funds then had to carefully navigate a path which would be fair to both redeeming and remaining investors whilst staying within the confines of the existing constitutional documentation. In difficult circumstances, investment funds sometimes had to rely on limited powers relating to redemptions in specie in order to meet the redemptions or were forced take the decision to suspend redemption rights or payment of redemption proceeds, sometimes for a protracted period.

Sometimes funds had to go through a process of canvassing the approval of the investors in order to attempt to minimise dissatisfaction and come to an acceptable solution for all concerned. Often, this was easier said than done. The impetus for the inclusion of specific soft wind down provisions created by such scenarios has also been borne out by case law in the Cayman Islands (and elsewhere) in the development of the "loss of substratum" doctrine in a series of cases since 2009.

Although not the focus of this article, the relevant case law seems to indicate that the incorporation of soft wind down provisions in fund documentation specifically contemplating the possibility of an indefinite suspension of redemption rights and payments and an orderly realisation of assets may assist in limiting the possibility of a successful application being made for a winding up on just and equitable grounds on the basis that there has been a "loss of substratum", meaning that the purpose for which the fund was established can no longer be carried out and that it has ceased to be viable as an investment fund. The incorporation of such soft wind down language should specify that any such soft wind down process shall be deemed to be integral to the business of the fund.

Navigating through illiquidity

The purpose of including soft wind down language is to enable the manager of a solvent fund to implement an orderly realisation and distribution of such fund's assets without a formal, protracted, and sometimes costly liquidation being immediately necessary. In these circumstances it might be preferable for the manager to carry out an orderly realisation of the assets rather than the being placed into liquidation and the liquidator being forced to undertake a "fire sale" of the assets, which would be to the detriment of the investors.

One of the options that may be taken in a soft wind down scenario is the use of a liquidating vehicle where assets may have become illiquid. Most commonly, Cayman documents may provide for redemptions of investors in specie rather than in cash, specifically via a distribution of non-redeemable shares in a special purpose vehicle established by the fund specifically to hold highly illiquid assets. As the illiquid assets held by the SPV are realised, the investors' shares in the SPV are compulsorily redeemed for cash. Such provisions should be built into the articles of association and explicitly disclosed in the fund's offering document and may be advantageous where the relevant manager is faced with a situation where some (or all) of the assets are highly illiquid and indivisible.

Vehicle choice for a liquidating vehicle

The most common types of vehicles used in a soft wind down are exempted companies and liquidating trusts.

Exempted companies are themselves the most common form of legal entity used in the Cayman Islands as investment vehicles and as special purpose vehicles. The memorandum and articles of association of the company can resemble that of "standard form" articles or may be customised to resemble "master fund" articles as long as, in each case, the shares are not redeemable at the option of the shareholders.

A liquidating trust is often used in structures involving exempted limited partnerships. Simply put a trust is not a separate legal entity, instead it is a relationship, the terms of which are governed by the trust deed. Most liquidating trusts take the form of a declaration of trust with the trustee declaring the terms on which the trust property is held for the underlying beneficiaries (or investors) and will be subject to a perpetuity period of 150 years. The trustee will in many cases be the general partner of the exempted limited partnership. There are no Cayman Islands requirements as to who can act as trustee of a liquidating trust, however, if the trustee is a Cayman Islands entity it will have to consider its licensing obligations under the Banks and Trust Companies Law (Revised). Some practitioners take the view that even where the general partner is a Cayman Islands company and wishes to act as trustee of the liquidating trust, the trustee will not require a trust license on the basis that the general partner (ie the trustee) is not carrying on "trust business".

It will be necessary for each fund wishing to implement a liquidating vehicle in a soft wind down to work with its onshore and offshore legal counsel and tax advisors in determining the appropriate form of special purpose vehicle having regard to the investor base of the fund, the fund's constitutional documents and the nature of the underlying illiquid assets.

No soft wind down provisions?

If there are no soft wind down provisions specifically included in the fund documentation, the directors of the relevant fund would need to carefully consider whether they should obtain the consent of the investors. This is a commercial question of risk assessment and depends very much upon the nature of the investor base and is therefore to be considered on a case by case basis. Depending on the voting structure of the fund, the investors may also be called upon to pass the special resolution required to amend the articles of association to include the soft wind down provisions.

Transfer of assets to a liquidating vehicle

If the fund documentation contains provisions that would allow for the transfer of assets to a liquidating vehicle, or the fund has sought and obtained the consent of the investors and is in a position to go ahead, there are generally two possible options for dealing with the relevant illiquid assets. It is possible that such assets may be transferred outright to the relevant SPV. However, frequently, illiquid assets cannot be transferred out of the name of the fund and in this scenario the fund and the SPV may enter into a contribution and participation agreement whereby some of the relevant assets may be transferred and some of the assets will continue to be held in the name of the fund but the fund will grant to the SPV a participation interest in the illiquid assets, in exchange for shares in the SPV.

Prevention is better than cure

To ensure that new funds going forward can rely on the flexibility afforded by the inclusion of soft wind provisions and the added protection against the possibility of a claim that there has been a loss of substratum of the fund we have described below some of the must-have features for fund documents:

  • allow for in specie redemption payments at the sole discretion of the board of directors (or general partner or trustee, as the case may be);
  • allow for in specie redemption payments to be effected, at the sole discretion of the board of directors (or general partner or trustee, as the case may be) by a transfer of the relevant illiquid assets directly to the redeeming investor or to a special purpose vehicle in exchange for an interest (such as a share or a beneficial interest under a trust) to be transferred directly to the redeeming investor;
  • allow for the possibility of an indefinite suspension of redemption rights and payments and an orderly realisation of assets specifying that any soft wind down process implemented shall be deemed to be integral to the business of the fund.

Looking ahead

In 2011 with the benefit of hindsight we can look back at the multitude of lessons learned from the 2008 global credit crisis. Funds and their advisers have already changed their standard form fund documents to provide for the unexpected difficulties faced by funds and the inflexibility of constitutional documents of past years. The inclusion of soft wind down provisions is one more step in providing options to a fund in managing assets through a difficult period or prior to a formal winding up.

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.