In ABC Company v J & Co Ltd, ABC was an open ended investment fund structured as a segregated portfolio company ("SPC"). Under Cayman Islands law, a company registered as an SPC may create segregated portfolios so as to segregate the assets and liabilities of one portfolio from other portfolios. Assets from one segregated portfolio are not available to meet liabilities of other portfolios.
J & Co was an investor in the 'German Fund' being one of 82 segregated portfolios of ABC. The German Fund undertook real estate investments. Due to a downturn in the property market, a decision was taken by ABC in 2008 to suspend redemptions in the German Fund for a period of 3 years during which time the portfolio's assets would be realised and distributed to creditors and shareholders. This course, it was said by the fund, would enable ABC to wind down the portfolio in an orderly manner (ie: a "soft wind-down").
ABC similarly suspended redemptions in its other portfolios holding investments in real estate, but left the remaining portfolios unaffected. The German Fund represented 0.85% of the real estate portfolios combined NAV, and the real estate portfolios in turn represented 32% of ABC's combined NAV.
J & Co petitioned to wind up ABC on the just and equitable ground on the basis that the SPC was unable to carry on the business for which it was incorporated (ie: it had lost its substratum). The petition was subsequently amended so as to apply in the alternative to wind up just the German Fund on the same grounds. ABC applied to strike out the winding up petition on the grounds that ABC could not possibly be said to have lost its substratum in circumstances where two-thirds of its portfolios were carrying on business as usual. Jones J at first instance declined to strike out. The Court of Appeal disagreed and unanimously held the petition was bound to fail.
In striking out the petition, President Chadwick delivering the judgment of the Court stated that:
- the provisions of the Cayman Islands Companies Law did not give the Court jurisdiction to wind up individual segregated portfolios of an SPC. The only remedy afforded by the legislation was the appointment of a receiver, and that was only available if the portfolio was insolvent – not on the just and equitable ground;
- in determining whether the substratum of ABC had failed, it was necessary for J & Co to establish that ABC had ceased carrying on business according to the reasonable expectations of its shareholders. Those expectations were to be gauged from the articles of association and relevant offering documents of ABC;
- ABC's articles of association permitted the directors in their absolute discretion and for any reason to suspend redemptions and subscriptions. Importantly in the opinion of the Court, the scope of the existing power to suspend redemptions contained in the articles was extended in 2010 by the passing of special resolutions of each class of participating shareholders. These amendments were passed some 2 years after redemptions in the German Fund had been suspended;
- ABC's offering memorandum warned that the liquidity of some of the investments held by the segregated portfolios could not be guaranteed. Any illiquidity may prevent, in certain circumstances, redemptions of shares;
- it was common ground that the directors of ABC acted in good faith in resolving to suspend redemptions in the real estate portfolios in 2008;
- no informed investor reading the articles of association and offering memorandum could fail to appreciate that the right to redeem segregated portfolio shares might be suspended; and
- it was therefore impossible for the petitioner to contend that ABC had ceased to carry on business in accordance with the reasonable expectations of its shareholders, or for that matter, in accordance with the reasonable expectations of the holders of shares in the German Fund.
Interestingly, although the Court of Appeal (correctly in our view) focused on the reasonable expectations of all shareholders in the SPC and not just investors in the German Fund, it did not appear to place any significance on the fact that two-thirds of ABC's portfolios continued to trade. Rather, emphasis was placed on ABC's power to suspend redemptions contained in its constituent documents, the bona fide exercise of that power by ABC's directors in 2008, and the effective ratification of the suspension 2 years later by a 75% majority of all classes of shareholders when they resolved to extend and clarify the power to suspend.
Although there was no language in ABC's articles or offering documents pointing to the reasonable expectations of shareholders being for the investment manager to undertake a soft wind-down, it is nonetheless unsurprising that the Court of Appeal decided J & Co's petition to wind up ABC was bound to fail. It would have been remarkable for the Court to have contemplated liquidating ABC in circumstances where the fund itself was not being wound down, and a substantial majority of shareholders were implicitly content with the directors' decision to suspend redemptions and had positively voted in favour of extending the power to suspend after the existing suspension had been in place for 2 years.
The Court of Appeal concluded its judgment by making reference to the topical issue in the Cayman Islands of the extent (if any) to which initiating a soft wind-down of a fund will constitute or indicate a loss of substratum.
The current position in the Cayman Islands with soft wind-downs (per Jones J) is that if there has been an indefinite suspension of redemptions, then it becomes practically impossible for a mutual fund to pursue its investment objective in accordance with its shareholders' reasonable expectations. The reasonable expectations of shareholders are to be gleaned from the fund's constituent documents. However, in considering those documents, the starting point is that there are strong policy considerations in favour of a fund being liquidated by qualified insolvency practitioners rather than on an informal basis by its management: the main consideration being that investment managers are skilled in investing, and for that, they are typically remunerated based on a percentage of NAV plus a performance fee. They are not skilled liquidators, and as a general statement of principle, should not undertake that role or be remunerated as such.
Conversely, in the British Virgin Islands (per Bannister J), the position is that fund managers are entitled to manage the wind-down of a fund and the only purpose for which liquidators should be appointed is to manage the final moments of the fund at the time when it should be put out of existence.
Although the "reasonable expectations of shareholders" approach of the Court of Appeal went some way to endorsing the views of Jones J, President Chadwick considered it unnecessary to decide the correct position because the issue on appeal was not whether it was just and equitable to wind up a fund in soft wind-down mode via an indefinite suspension of redemptions and managed realisation of assets (ie: the appeal related to ABC as a whole and not just the German Fund). Consequently, the difference of opinion between Jones J in the Cayman Islands and Bannister J in the BVI on the implications of a soft wind-down remains to be resolved. Curiously though, after noting that the point would no doubt arise in due course for adjudication at appellate level, the Court of Appeal suggested that the answer may lie somewhere between the two competing approaches.
Based on the process the Court undertook in the ABC case, it would not be surprising if the "middle ground" alluded to by President Chadwick is for the Court require the presence of express soft wind-down language in the fund's constituent documents: so if there are specific powers to suspend redemptions indefinitely and for the manager to realise assets for the benefit of investors over time, which powers are then activated, the Court may determine that there is no ground to wind up the fund based on loss of substratum.
The consequences of the Court of Appeal's judgment for investment managers are telling.
First, individual portfolios of an SPC are immune from being placed into receivership or wound up on the just and equitable ground on application by a disgruntled investor (unlike the position with feeder funds in a typical master/feeder structure). This of course is a positive outcome for managers. Conversely however, the risk is that the only remedy available to any such investor, should circumstances permit, is to petition to wind up the entire SPC rather than just one limb. That risk is mitigated to the point of remoteness if the articles and offering documents of the fund are properly drafted.
Secondly, investment managers must ensure that the terms of the constitution and offering documents of the fund, whether it be an SPC or some other vehicle, are crystal clear on the rights and consequences attaching to a suspension of redemptions. In particular, the inclusion of soft wind-down language will serve as evidence of the reasonable expectations of shareholders that the manager may properly implement an indefinite suspension of redemptions in order carry out a soft wind-down of the fund.
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.