This article originally appeared in Offshore Funds Today. To read the magazine in it's entirety please click here.
The drafting changes just discussed are primarily intended to ensure that funds do not become embroiled in contractual disputes, but in a global recession more and more funds are finding themselves in disputes that threaten to end up, and sometimes do end up, before the courts. In this chapter we analyse the legal issues surrounding key matters in the current litigious environment and cover the following:
- NAV restatements and clawbacks
- claims against service providers
- shareholders status as creditors and/or members
- recent changes in Cayman's insolvency regime
- international co-operation in liquidations
Recalculation of Published Net Asset Values
A recurring question, which is still untried in the Cayman courts, and which has arisen in the context of several liquidations in which we are involved, is whether it is possible for a fund to restate a NAV once it has been published. If so, can a fund or its liquidator clawback payments made to investors following the discovery of an overstated NAV?
The Cayman courts are yet to determine whether, in the discharge of their duties, liquidators of Cayman companies are able, as a matter of principle, to recalculate NAVs (and the individual values attributed to a company's assets) which were finalised prior to the commencement of the liquidation.
In our view, it is unlikely, subject to certain fraud related exceptions and the particular terms of the fund documentation, that a fund or its liquidator may unilaterally adjust previously settled NAVs.
Many funds, within their governing documentation, make specific provisions allowing their directors to recalculate published NAVs in circumstances where a NAV was based on mistake or error. The reasoning behind this is simple: the NAV should reflect the true value of the fund, and where a mistake or error is evident, that mistake or error ought be capable of being rectified. However, such provisions are usually limited to a "hold back period", usually after the NAV has been calculated but prior to a year -end audit, and during which time a percentage (usually 5% or 10%) of the redemption price is withheld pending completion of the fund's audit. Should an adjustment to the NAV be necessary, the Fund is able to recover any "over payment" from those monies withheld, and remit the balance to the redeeming investor. Whether such a hold back provision, of itself, will be sufficient to enable a unilateral recalculation of a NAV will ultimately be a matter of construction of the particular document. It is, therefore, not uncommon for provision within a fund's governing documentation to provide that the NAV is not finally determined until completion of the year-end audit.
Even if such provisions are present, it is not clear that this entitles the fund to recalculate the NAV in the light of information available only after the date for which it is calculated.
There are opposing views on this: on one side, a NAV is to be recalculated to its true value, in light of information available subsequently. On the other side, the view is that the NAV is to be calculated on the notional basis of what would have been realised if disposed of on that date - and which necessarily excludes information not available on that date. Our position is that the latter position is correct.
Most funds' governing documentation includes some form of final and binding provision with respect to NAVs, to the effect that once a certificate is issued declaring the NAV, this is a final determination binding on all parties.
In In the Matter of Livingston International Fund Ltd. (In Liquidation) (Unreported 2004, High Court of Justice, British Virgin Islands, Rawlins J.) the BVI Court was required to determine whether there was any legal basis to recalculate previously settled NAVs. There, the Court was required to determine the point based on documents with a "final and binding NAV" clause, and no holdback provision. It was not disputed that the NAV, calculated on a monthly basis, was significantly wrong (to the tune of 50%) for three months during 2001. In finding that the liquidators were not entitled to recalculate the NAV, the presiding judge commented as follows:
"...However, [the final and binding NAV clause] of the Articles of Association of the Fund is intended to promote certainty and business efficacy. Investors, particularly significant investors in private funds, make far reaching decisions and, in turn, incur significant financial obligations on the basis of reported NAVs. [One investor], for example, ... relied on the NAVs that the Fund issued in arriving at the decisions and managing the Funds of its own investors. For purposes of business efficacy in this case, I see no good reason to find that the published NAVs are not binding ...".
A Bermuda Court was likewise unwilling to allow a recalculation of the NAV. In In the Matter of Stewardship Credit Arbitrage Fund, Ltd (Unreported, 266 of 2008, Supreme Court of Bermuda, Bell J) the Court was faced with the issue as to whether a recalculation of the NAV was, as a matter of law, possible. As with Livingston a provision providing for finality was included in the fund's governing documentation. That provision was in the following terms:
"Any certificate as to the Net Asset Value, a Class NAV, a Series NAV or the Net Asset Value per Participating share of any Class or Series or as to the Subscription Price or Redemption price therefore given in good faith by or on behalf of the Board shall be binding on all parties".
The overstatement necessarily arose as a result of a fraud committed by Mr. Petters. Mr. Petters was the controlling mind of a number of companies in which the company in question, Stewardship, invested approximately 70% of its assets. As a result of Mr. Petters' actions, the real value of Stewardship's investments in the "Petters companies" was significantly lower than recorded in Stewardship's book and records, as reflected in its NAV. In finding that the NAV was unable to be recalculated, the Court commented as follows:
"...There is no logic in simply recalculating the NAV at the redemption date for the Gottex Funds of 31 March 2008, when the Petters Fraud was not discovered until some months later; there would also be a need to effect a recalculation of the position when the Gottex Fund first invested, and no doubt also in relation to all other redemptions and subscriptions. As Mr. Potts puts it, it would be necessary to unravel the entire operation of the fund and the magnitude of such a task cannot be over emphasised. It also seems to me that to do the exercise properly, the Company would need to know the true position in relation to the value of the underlying loan collateral for each revision date, or, put another way, the extent of the Petters Fraud in relation to each such collateral, a truly impossible task. No doubt that is precisely why the relevant bye-law contained the provision which it did, making for certainty once the NAV had been determined".
The Courts' rulings in each of Livingston and Stewardship are, in our view, compelling. Whilst these decisions would not be binding on the Cayman Court, they would be highly persuasive.
There does, however, appear to be one avenue which remains untested - fraud. There is a long standing legal maxim "fraud unravels everything". Whilst Stewardship did arise in circumstances where a fraud had been committed, that fraud was committed within the context of a group of companies in which the relevant fund invested, not within the fund itself. It may be open to argue that the NAV ought be recalculated in circumstances where the NAV has been overstated as the result of a fraud having been committed against the fund itself.
If it is possible to restate a published NAV, the question then necessarily becomes: what action can be taken to recover those sums already paid out to investors at the inflated value?
We expect to see a number of cases relevant to this issue arising out of the Madoff affair. Irving Picard, the SIPC trustee (Securities Investor Protector Corp.), has already made it clear he will be looking to clawback the profit element of Madoff redemption funds from direct customers. Whilst this will be played out in the US courts we expect that some of these direct investors may look to their own investors to pass on the clawback liability.
Any such claim in either Cayman or the BVI would be brought either under the contractual provisions in the relevant fund's articles, or under common law principles of mistaken payment or unjust enrichment. Unlike private equity partnership provisions, corporate hedge funds do not typically include contractual clawbacks.
Unless there is some express contractual provision allowing clawback, it seems highly unlikely that any liquidator or fund may be able to clawback payments once paid out. The common law provides any bona fide recipient of funds paid out in error or arising out of a mistake with a "change of position" defence, which makes it inequitable for the redemption proceeds to be restored. A recipient in such circumstances is able to resist a claim if it has received the funds and paid them on, for example, to its own investors. If a BVI or Cayman fund which has received a payment from Madoff is subject to a claim from the SIPC trustee, then we would expect the liquidator to reject the claim (on the basis of innocent receipt and a change of position). The SIPC trustee might appeal to the court and if the court reverses the rejection, the liquidator might consider clawback claims against the shareholders. However, the possibility of succeeding with such a claim seems very remote and accordingly we do not expect to see such speculative actions being initiated.
It remains to be seen whether the Cayman courts will follow Bermuda and BVI in the question of restatement of NAVs. It also remains to be seen whether the Madoff clawback claims by the SIPC trustee trigger clawback claims against indirect Madoff investors. Amongst the claims that have been made to date are claims against Fairfield Greenwich's three BVI funds: J Ezra Merkin's funds, including Ascot Partners, a US fund; Ariel Fund, a Cayman fund; and against Harley International, a Cayman fund. Accordingly, it is not yet clear whether funds' documents should provide additional flexibility to restate NAVs in the event of error or fraud. For now, on balance, we prefer to stick with the current provisions. Any provisions that allowed for revisions of NAV may increase litigation and claims.
Claims Against Directors And Service Providers
Looking beyond claims brought or threatened against funds themselves, we are seeing an increase in actual or potential claims by liquidators (or by shareholders by derivative action) against directors or other service providers. In neither Cayman nor BVI is there statutory regulation of indemnity or exculpation clauses and it remains common practice to include such provisions in the constitutional and contractual documents. By way of example, set out below are indemnity provisions from Ogier's standard form of Articles of Association:
163. Every Director (including for the purposes of this Article, any alternate Director appointed pursuant to the provisions of these Articles), managing Director, agent, Secretary, or other officer for the time being and from time to time of the Company and the personal representatives of the same shall be indemnified and secured harmless out of the assets and funds of the Company against all actions, proceedings, costs, charges, expenses, losses, damages or liabilities of whatsoever nature and howsoever arising incurred or sustained by him otherwise than by reason of his own Gross Negligence or wilful default in or about the conduct of the Company's business or affairs or in the execution or discharge of his duties, powers, authorities or discretions, including without prejudice to the generality of the foregoing, any costs, expenses, losses or liabilities incurred by him in defending (whether successfully or otherwise) any civil proceedings concerning the Company, its business or its affairs in any court whether in the Islands or elsewhere.
164. The Administrator, the Investment Manager and any other agent which the Company has appointed shall be entitled to such indemnity from the Company under such terms and subject to such conditions and exceptions and with such entitlement to have recourse to the assets of the Company with a view to meeting and discharging the cost thereof as shall be specified in the relevant contract or instrument appointing such agent.
The meaning of terms such as fraud, dishonesty, personal dishonesty, wilful default, gross negligence and the like are matters for determination by the Court. There can, in any event, be no exculpation or indemnity for fraud or dishonesty as any such provision would be contrary to public policy in Cayman and BVI and would not be given effect to. In addition, there is first instance Cayman authority that it is not permissible for directors to exclude or be indemnified for liability arising out of their own wilful default or wilful neglect as the court held that this would be inconsistent with the core fiduciary duties to which they are subject.
In many instances, the term "gross negligence", which has no statutory definition in Cayman or BVI, may be afforded a contractual definition such as "a standard of misconduct beyond negligence whereby a person acts with reckless disregard for the consequences of his action or inaction" to provide guidance to and clarification for the courts in interpreting such a clause.
We have seen many posturing and pre-litigation letters, but in the light of broad indemnity provisions and the difficulty in establishing that a director or service provider has been grossly negligent, we have not seen any court action by investors. We expect that some claims by liquidators may yet be pursued and we anticipate that the Court decisions arising will provide important guidance and authority on the fiduciary and contractual duties owed by directors and service providers and permissible exculpation and indemnification provisions.
Shareholders: Creditors Or Members?
We have already discussed the recent Cayman Court of Appeal decision in In the Matter of Strategic Master Partnership Limited which confirmed that, in general terms:
- where an investor has served a redemption request and the redemption day to which it relates falls before the commencement of the liquidation, that investor is a creditor in respect of any unpaid redemption price due; and
- where an investor has submitted a redemption request but the redemption day to which it relates falls after the commencement of the liquidation, the redemption will not be capable of enforcement and so no obligation to pay the redemption price will arise. As such, that investor will remain a member of the fund in respect of those shares.
In Cayman, the "commencement of the liquidation" is either the time at which the resolution to commence winding up is passed by the members, or the time at which a petition for the appointment of a liquidator is presented to the Court. This timing for Cayman Court petitioned liquidations is worth highlighting as the petition may be presented to the Court several weeks and sometimes months before the Court grants the petition to appoint the liquidator. In contrast, liquidation under BVI law is deemed by statute to commence on the granting by the Court of the petition to appoint the liquidator or on the passing of the resolution. From an operational and administrative standpoint, Cayman law provides that any disposal of property and any change in the status of members in the period between the petition being presented and it being granted by the Court (such as any redemption) is void unless the Court determines otherwise.
It is also worth noting that the Insolvency Act in BVI goes further and prevents "past members", being members who have redeemed during the period of one year before the commencement of a liquidation, from making a formal creditor's claim in a liquidation for unpaid redemption proceeds. As such, a past member of a BVI fund will, in respect of any unpaid redemption proceeds, rank alongside members who have not redeemed their shares.
The significance of whether an investor is truly a creditor or a member arises in terms of the priority of the relevant claim:
Creditors - investors who are determined to be creditors upon the commencement of the liquidation of the fund rank behind secured and unsecured third party creditors (i.e., those whose debts do not represent payments in respect of their shares) but ahead of the members.
Members - investors who are determined to be members upon the commencement of the liquidation of the fund are entitled to participate only in the surplus assets of the fund following settlement of all of the fund's liabilities to its creditors.
Recent Changes In Cayman's Insolvency Regime
Liquidation is often regarded as the refuge of last resort, when all other means (such as the use of liquidating trusts, synthetic side pockets, successor funds, new share classes etc.) have failed. However, recognising that liquidation is a fact of corporate life, the liquidation regime has been updated and amended in Cayman with effect from 1 March 2009.
The new regime, as set out in the Companies Law (Revised), the Foreign Bankruptcy Proceedings (International Cooperation) Rules and the Grand Court Rules, provides Cayman with a comprehensive, flexible, self contained, creditor-friendly regime for corporate liquidations which includes specific provisions to facilitate international co-operation in cross-border insolvencies. The BVI has a similar insolvency regime provided for within its Insolvency Act.
There are a number of important changes which are the subject of separate detailed Ogier briefing notes. In order to understand the changes in the insolvency environment we review below the principal changes to the winding up options available as a result of the new insolvency regime and also review the new provisions dealing with international co-operation on cross-border insolvencies.
Under the new regime, there remain three kinds of winding up: compulsory, voluntary and voluntary under court supervision (for all practical purposes the same as compulsory winding up).
Compulsory Winding Up
The new regime retains the previously existing cash flow test for solvency, namely that the fund concerned must be able to pay its current debts from its currently available assets to maintain solvency. In addition, a balance sheet test evidencing that long term liabilities exceed long term assets, can provide a basis for a petition on the grounds that it is just and equitable that a fund be wound up. The just and equitable basis for petitioning was traditionally the refuge of shareholders and was commonly regarded as the option of last resort by the Courts. We anticipate that the Courts will remain conservative in their granting of petitions sought on a just and equitable basis, but the new regime does enhance the Courts' powers by specifically authorising various alternative orders in the face of such a petition, including:
- to regulate the future conduct of the fund's affairs;
- to restrain the fund from doing or continuing the act complained of or to order that an omitted act be completed;
- to authorise the petitioner to bring civil proceedings in the name, and on behalf, of the fund concerned; and
- to order the purchase of shares held by a shareholder by any other shareholder or by the fund itself, so that the court can require majority shareholders or the fund to pay out minority shareholders who are being prejudiced or potentially prejudiced by the actions of the majority.
Those entitled to petition for compulsory winding up are:
- the fund itself, by special resolution of its members;
- the directors of the fund without a members' special resolution (limited to funds incorporated after 1 March 2009 with provision in their articles);
- creditors, which includes contingent and prospective creditors but excludes claims disputed by the fund; and
- shareholders holding partly paid shares or who have held fully paid shares for at least six months or who have become entitled to shares following the death of the former registered holder.
The principal reason for these restrictions on the right of shareholders to petition is to place constraints on so called "vulture funds" or asset strippers from acquiring shares with intent to liquidate the fund for the purposes of releasing specific assets.
Voluntary Winding Up
Generally, voluntary liquidation (without the supervision of the Court) is the preferred practice for funds as this enables the manager to run off the portfolio, pay out all creditors and redeem shareholders following which the fund is formally wound up and dissolved. The circumstances for voluntary winding up have been clarified, expanded and in certain respects, narrowed.
A voluntary winding up of a company will now commence automatically in cases where a period fixed by its memorandum or articles of association expires, without the need for a resolution of the shareholders (resolving the present controversy as to the need for such a resolution in those circumstances). A special resolution is otherwise required, save that an ordinary resolution suffices for winding up because the company is unable to pay its debts as they fall due.
A significant change is that, where a company is being wound up voluntarily, the liquidator must apply to the Court for an order that the liquidation continues under the supervision of the Court, unless within 28 days of the commencement of the liquidation, the company's directors have signed a declaration of solvency in the form prescribed in the new rules. This brings all insolvent voluntary liquidations into the control of the Court. Additionally, the new regime requires that all Court supervised liquidations must be conducted by suitably qualified insolvency practitioners.
Provisional Liquidators; Shadow Directors; Voidable Preferences
The new regime introduces the concept of provisional liquidators and provides for their appointment where there is a prima-facie case for the winding up of the fund and where the appointment is deemed necessary for the prevention of the dissipation or misuse of the fund's assets, the oppression of minority shareholders or the mismanagement or the misconduct on the part of the directors.
In addition, provisional liquidators may be appointed on application by the fund, ex parte, which is a particularly useful protection for a fund where a compromise arrangement with creditors or an agreed restructuring or reorganisation to allow the fund to continue, is proposed.
The new regime also introduces into Cayman law and practice:
- the concept of shadow directorships, such that any person who exerts such influence over the conduct of duly appointed directors as to make them comply with his or her directions, will be subject to the same personal liabilities as a formally appointed director and may (there is no Cayman case law on this issue) acquire some or all the fiduciary duties of a director;
- the power for the Cayman courts to make winding up orders in respect of companies incorporated outside Cayman where such company has property in Cayman, is carrying on business in Cayman, is a general partner of a Cayman exempted limited partnership or is registered in Cayman as a foreign company pursuant to the Companies Law; and
- new provisions relating to fraud, voidable preferences, avoidance of dispositions at under-value and fraudulent trading which clarify those transactions entered into prior to the commencement of a liquidation, which may be voidable, thereby allowing the liquidator to recover additional assets. Thus, any payment made to a "related party" (which includes any party exercising control or significant influence over the affairs of the company) at a time when the company is insolvent is voidable.
Winding Up Of Exempted Limited Partnerships
Cayman has also recently brought into effect amendments to the Exempted Limited Partnership Law which apply many of the new corporate insolvency and liquidation principles and procedures to the winding up and dissolution of exempted limited partnerships. A Cayman exempted limited partnership will continue to be wound up in the circumstances set out in its partnership agreement (such as on the expiry of a contractual term or the occurrence of some other specified event) but, in addition, will be wound up:
- by means of a resolution of all of the general partners and a two thirds majority of the partners as a whole (unless the partnership agreement specifies different majorities); and
- upon Court order, on application of a partner or a creditor of the partnership, if the Court is satisfied that the winding up is just and equitable.
The changes also extend to partnerships the voidable preferences provisions.
International Co-Operation On Cross-Border Insolvencies
The final component of the recent legislative changes is the introduction of specific provisions, akin to Chapter 15 of the US Bankruptcy Code, aimed at promoting cooperation in cross-border insolvency cases in application of the model law promulgated by UNCITRAL. The new provisions empower the Cayman courts to:
- recognise the right of a foreign representative to act within Cayman on behalf of the entity;
- stay proceedings or enforcement of judgments against the entity in Cayman;
- require the production of information relating to the business of the entity; and
- turn over to the foreign representative any property belonging to the entity.
Whereas the recent Bear Sterns and Sphinx cases have suggested that the US bankruptcy courts are adopting a restrictive approach to relief under Chapter 15 through stringent application of the "centre of main interests" test, the Cayman provisions require only that the debtor is a foreign entity subject to a foreign bankruptcy proceeding in the jurisdiction in which it is incorporated or established.
Additionally, by virtue of the new provisions, Court appointed or supervised liquidators are under a duty to consider whether or not it is appropriate to enter into international protocols or agreements, sanctioned by the Court, with foreign representatives. We have already seen this provision in action, even before the legislation was enacted, in connection with the cross-border proceedings relating to the Lancelot and Colossus group of funds. In December 2008, the Cayman Court ordered a stay on the appointment of Cayman liquidators to allow the proposed liquidators and US trustee in bankruptcy to negotiate and conclude a protocol on the conduct of the proceedings. We have been advised recently by the Cayman liquidators that, pursuant to the proposed protocol, they will undertake responsibility for the recovery of the assets and settlement of the liabilities of the Cayman entity subject to certain reporting obligations, particularly with regard to remuneration, to the US bankruptcy court, leaving the US trustee in bankruptcy to attend to the US entities.
BVI has similar cross-border insolvency provisions within Part XVIII of the Insolvency Act, although these provisions are not currently in force. In light of the coalescing of standards amongst jurisdictions and the focus on co-operation internationally, there may be some momentum to bring these provisions into effect during 2009.
The changing international landscape brings us on to our final module in which we look at the tax and regulatory initiatives which are reshaping the environment in which offshore funds operate.
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.