The recent decision of the Grand Court of the Cayman Islands ("the Court") in the case of FIA Leveraged Fund1 has laid down, for the first time, the principles applicable to an in specie (or in kind) distribution of fund assets to investors.
The documents which make up the contractual arrangements between a hedge fund and its investors commonly give management the power to satisfy a redemption request by distributing assets in kind rather than making a cash payment. This is the first time the Court has delivered a judgment regarding the manner in which that power is to be exercised.
The decision emphasised that the power must be exercised in a manner which gives commercial efficacy to the obligations owed by a fund to its investors, and in accordance with the fiduciary duties owed by management to investors. The purported exercise of the power in a manner which did not accord with those principles did not discharge the debt owed by the Fund to its shareholders, who were therefore entitled to have the Fund wound up on the ground of insolvency. The Court also held that the circumstances of the purported distribution in this case justified a winding-up on the just and equitable ground, on the basis that the Fund had lost its substratum (i.e. the purpose for which the Fund had been incorporated was incapable of achievement).
In this case, the petitioning investors (the "Petitioners"), three US pension funds, were owed redemption proceeds of US$144,500,000.
Rather than meeting the redemption requests in cash, the Fund sought to satisfy those requests by issuing promissory notes. The Fund's Offering Memorandum permitted shares to be redeemed in kind, and provided that the value of assets paid out in kind "shall be determined by the Board of Directors in consultation with the Investment Manager in its sole discretion."
The Petitioners were unsatisfied with the purported in kind redemption, and issued a winding-up petition. The petition asserted that they were unpaid creditors, that the Company was unable to pay its debts and it should be wound up pursuant to Section 92(d) of the Companies Law (2011 Revision) ("the Law"). Alternatively, they sought a winding up on the just and equitable ground pursuant to Section 92(e) of the Law, on the basis that the Fund had lost its substratum.
The question of whether the issue of promissory notes validly discharged the obligation to pay redemption proceeds did not fall to be determined because, following the issue of the petition the Fund transferred certain assets into a newly incorporated Delaware entity, and caused the shares in that entity to be registered in the Petitioners' names.
The Fund asserted that there was a genuine dispute as to whether the Petitioners had been properly redeemed by way of an in kind distribution that realistically represented the value of their entitlement. If indeed there had been a genuine dispute, this would not have been suitable for resolution on a winding-up petition, but would have had to be resolved by way of an action commenced by writ.
The Court concluded, however, that there could be no genuine dispute that the Fund owed a very substantial debt to the Petitioners which had not been satisfied by the purported in kind distribution. On analysis, the fact emerged that unless the Petitioners were willing to pay an additional US$65 million to exercise a stock purchase option by 26 May 2012, the new shares would be worthless. The worthless assets selected for distribution to the Petitioners had to be viewed in the light of the Fund structure as a whole, which was said to be worth US$37 million in excess of the value attributed to the new shares.
The Court went on to consider whether the debt had been validly discharged by the Fund by reference to its contractual documents. The Fund pointed to the "sole discretion" granted to management to determine the value of the assets distributed. However, the Court found that it would not be reasonable to conclude that the Company's contractual documents vested in the directors of the Company an exclusive and absolute discretion to effect an in kind distribution which would not give commercial efficacy to the obligations owed to the investors by virtue of the Company's contractual documents. The Court also emphasised the fiduciary duties of care and to act in good faith which the directors owed to the investors, which the Court would not construe as having been "impliedly swept aside" by the contractual documents.
The Court concluded that the asset which management had selected for distribution to the Petitioners was commercially worthless when compared to the value of the debt it purported to redeem. It therefore did not discharge the debt owed to the Petitioners, and in relation to which they had served a statutory demand.
The Court also found that, quite apart from its deemed inability to pay its debts following non-compliance with a statutory demand, the Company was "very doubtfully solvent" on the cash flow basis (which is the only basis for an insolvent winding up in the Cayman Islands pursuant to section 92(d) of the Law).
The Court went on to record that, given the circumstances in which the Fund's management had selected assets for distribution to shareholders and attributed value to those assets, it was clear that "it is no longer possible for the purposes for which the Company was formed – to maximise shareholders' investments – to be achieved." There was therefore a reasonable basis for apprehension on behalf of the Petitioners that the Fund's substratum had failed. As such, the facts justified the granting of a winding up order on the just and equitable ground, as well as on the ground of insolvency.
This judgment follows a line of recent Cayman cases where a flexible test for loss of substratum as a ground for just and equitable winding-up has been adopted and funds which have ceased to be viable have been wound up for loss of substratum. This line started with Re Belmont Asset-Based Lending2 in 2010 and continued with the 2011 decision in Heriot-African Trade Finance3. It has been widely noted that the Commercial Court in the British Virgin Islands has expressly declined to follow the approach taken by the Cayman court in this regard4 The Chief Justice did not take the opportunity in his judgment to comment on the differing approaches taken by the Cayman and BVI courts, confirming that the test for loss of substratum would be met whichever test were adopted. Like those cases, this judgment confirms the Court's willingness to grant a winding up order to ensure the protection of investors in an appropriate case.
We understand that this decision may be subject to appeal by the Fund.
1.Unreported, decision of the Chief Justice dated 23 April 2012
2. [2010(1)] CILR 83
3. [2011(1)] CILR 1
4. Aris Multi-Strategy Lending Fund Ltd and Quantek Opportunity Fund Ltd, Claim No BVIHCOM 2010/0129.
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