The Cayman Islands Court of Appeal has recently handed down its written reasons for dismissing the FIA Leveraged Fund's appeal from a judgment of the Grand Court which ordered that the Fund be wound up on the petition of three redeeming investors whose redemption requests had purportedly been met by distributions in kind. Although the decision turned on the specific facts of the case, the Court's judgment emphasises once again the primacy of the investment agreement between the fund and its investors, as well as the importance of valuation and timing issues when a fund is considering paying out a redeeming investor other than in cash.
In April 2012 the Grand Court heard the winding-up petition in respect of the FIA Leveraged Fund (the "Fund") which had been presented by three creditors, which were US public employee pension Plans. The fund was a typical Master/Feeder structure, comprised of the Fund as feeder and another Cayman exempted limited company as the Master Fund. The Fund and Master Fund were managed by an investment manager in Bermuda and were members of the wider Fletcher funds group. The terms of the series of shares of the Fund into which the Plans had made their investments as to redemption provided that shares were redeemable at the end of each calendar month on sixty days' prior written notice and that 90% of the redemption amount was payable with a true-up of the balance when the Fund had finally determined the redemption price of each share. Also, and in respect of this series of shares, a supplement to the offering memorandum provided that the Fund was obliged to pay 90% of the redemption amount in cash or in kind within 15 calendar days of the redemption date, with up to 10% being retained until no later than 30 days after the completion of the Fund's audit for the year in which the redemption amount was payable.
The first petitioner, FRS, made two redemption requests for separate amounts, first on 14 March 2011 and the second (in respect of the balance of its shares) at the end of June that year. MERS, the second petitioner, made a redemption request first on 3 March 2011 and a second such request, again seeking to redeem the balance of its investment in the Fund, on 22 June. Finally, the third petitioner, NOFF, made a redemption request on 27 June 2011 in respect of all of its shares.
In response to these requests, the Fund distributed promissory notes (which had been issued to it by the Master Fund) to FRS and MERS on 15 June in purported satisfaction of their first redemption requests. The notes were rejected by each investor, which alleged that they did not discharge the debt which was owed to them by the Fund. There then followed a series of extensions of time for the Fund, but the Fund was unable to make payment by the final agreed extension of 15 December 2011. The Plans therefore presented the winding-up petition at the end of January 2012, alleging that no payment had been made to them in satisfaction of their outstanding redemption requests. The petitioners also alleged that it was just and equitable that the Fund should be wound up for reasons which it was not necessary for the Court of Appeal to consider and which will not be considered further here.
In defence of the petition the Fund contended that it had in fact paid the amounts due to the Plans by way of distributions in kind, comprising, first, the promissory notes and assignments, and secondly, the issue on 13 February 2012 (some two weeks after the presentation of the petition) to the Plans of shares in a new special purpose vehicle ("SPV"), which held investments formerly held by affiliates of the Master Fund and which had been created for the purpose of acting as a vehicle to facilitate a distribution in kind to the Plans. The mechanics of the transaction by which the redemptions in kind were purportedly made were set out by the director of the Fund in his evidence opposing the petition. As he explained, the Master Fund did not in fact make direct investments itself but invested in other funds in the same Fletcher group of funds, which then invested in other funds in that group, and these affiliates had contributed assets which they held to the SPV in order to ensure that the assets held by the SPV were sufficient to satisfy the balance owed to the Plans by the Fund. The relevant resolutions of the Master Fund and the Fund were produced in evidence and showed the chain of decisions pursuant to which the directors of the funds transferred certain underlying assets of one fund in the Fletcher group into the SPV, ascribed a value to those assets, and a resolution of the Fund that the transfer of shares was to effected to satisfy in kind 90.15% of the value of the petitioners' redemption requests.
The assets transferred to the SPV, the shares of which were issued to the Plans, were examined during the trial of the petition. They comprised a right – acquired by one of the Fletcher group funds – to invest US$65 million in the series C convertible preference shares of a publicly traded US bank ("UCBI"). The right to invest carried with it a potential perpetual right to income which might be called by UCBI 5 years from the date of the investment which, if called, would be converted to a right to common stock and a further US$35m of warrants in the common stock in UCBI. However, in the period since the right was acquired UCBI had announced a reverse stock split under which each 5 preferred shares in UCBI would be cancelled and replaced with one share. That led to uncertainty as to just what the right comprised and uncertainty as to its value, although the directors of the Fund had adopted the higher of the possible values when valuing the asset for the purposes of the transaction.
There were two questions for the Court of Appeal to decide on the appeal. The first was whether the Fund was entitled to make a distribution of the shares in the SPV to the Plans in order to redeem the Plans' investments in kind. If the answer to the first question was yes, the second question was whether the directors had properly exercised their discretion in adopting the higher valuation of the asset held by the SPV when valuing the SPV for the purposes of the redemption.
In relation to the first question, the Court of Appeal held that the answer to it depended on the construction of the investment agreement (comprised by the articles of association of the Fund and the relevant offering documents) between the Fund and its investors. The Court noted that clause 11F of the articles of association provided that:
"Subject to the next paragraph of this article, amounts due on redemption for participating shares redeemed will be sent ... as follows: At least 90% of the amount estimated by the directors to be due on redemption shall be paid by the company generally within 35 days of the date that the shares were redeemed and the remaining amount shall be paid when the company has finally determined the redemption price for the participating share. If the initial payment made by the company exceeds the finally determined redemption amount, that holder shall repay to the company on demand the amount of any such excess. With respect to series N shares, the company will pay at least 90% of the redeemed amounts in cash or in kind without interest within 15 days of the date that the shares were redeemed and the company, subject to the discretion of the directors, will retain up to 10% of such redemption until no later than 30 days after the completion of the audit of the financial statements relating to the fiscal year of the company in which the redemption occurred."
This was supplemented by a clause in the offering documents which stated:
"An investment in the fund provides limited liquidity since the shares are not freely transferable and investors generally may redeem their shares only at the end of a calendar week. There can be no [assurance] that the fund will have sufficient cash to satisfy redemption requests or that it will be open to liquidate investments at the time of such redemption request at favourable prices. Under the foregoing circumstances and under other circumstances deemed appropriate by the board of directors, investors may receive in kind distributions from the fund's portfolio. Such investments so distributed will not be readily marketable or saleable and may have to be held by such investors for an indefinite period of time. As a result, the investment is suitable only for sophisticated investors."
By reference to these provisions, and provisions in the offering documents which contained provisions that were nearly identical to the second part of clause 11F quoted above, the Court of Appeal held that "the intention is that, if an investor seeks to redeem at a time when the Fund is illiquid, his request can be satisfied by transferring to him an asset which is held in the Fund and is available for distribution." As at 15 September 2011, that being the date on which the Plans were entitled to be paid (that date being 15 days after the right to be paid out crystallized) the assets which were distributed to the Plans were not assets belonging to the Fund; in fact they did not exist at all because the SPV had not been incorporated as at that date.
Having decided that the distribution in kind was not a valid distribution under the terms of the investment agreement, it followed that the Plans were creditors of the Fund which had not been paid and that the Grand Court was right to have ordered the winding up of the Fund.
In light of that, it was not strictly necessary for the Court of Appeal to decide the second question, but it went on to consider the point in the event that its answer to the first question was incorrect. The second question was whether the directors had properly exercised their discretion to ascribe the value which they had to the asset transferred to the SPV. As mentioned above, there was uncertainty about what the right entitled the holder to receive, which lead to two widely different valuations, the higher of which the directors had adopted for the purposes of the redemption in kind.
The Court of Appeal held, first, that there was no evidence that the directors of the Fund actually applied their minds to the question of value as at the time the transfer of the asset to the SPV was effected. The directors simply adopted an internal valuation which had been arrived at by parties within the Fletcher funds group. Secondly, the only formal valuation that was before the Court was dated two weeks following the purported in kind distribution. Thirdly, there was a subsequent report that showed the very great variance in the value of the asset, depending on the view one took of the UCBI reverse share split, but no evidence that the directors had taken that issue into account when arriving at their valuation, such that their exercise of discretion could not be said to have been rational. And fourthly, it was no answer for the directors to say, in relation to the third issue, that they had a complete discretion in ascribing the value which they did to the asset – in this context the Court of Appeal applied the English Court of Appeal's decision in Zuckerman International Bank v Standard Bank (London) Limited (2008), in which it had been held that "a decision maker's discretion in circumstances of this nature is limited as a matter of necessary implication by concepts of honesty, good faith and genuineness and a need for the absence of arbitrariness, capriciousness, perversity and irrationality".
As noted at the outset, this decision turns on the specific terms of the investment agreement which the Plans made with the Fund when they made their investment and the somewhat peculiar factual circumstances of the case. The terms which were scrutinized by the Court are however fairly standard in the market and the decision will therefore be of wider interest.
There are also interesting questions raised by the judgment. The first question is whether the Court was right to decide what it did in relation to the distribution in kind issue. The Court of Appeal held that the redemption in kind was invalid because the shares in the SPV, rather than the asset which was transferred to the SPV, did not exist and were not therefore part of the Fund's portfolio as at the date when the Plans were entitled to be paid (i.e. 15 days after the redemption date). But does that actually matter? If a person is owed the proceeds of redemption, and the debtor is entitled to make a payment in kind, what does it matter if the asset does not come into the debtor's possession until after the date for payment has passed as long as the asset is of a value equal to the debt? What the Court of Appeal has effectively done is read the provisions together in order to hold that the right to redeem in kind may only be exercised within the time limited for doing so by using assets from within the Fund's portfolio at that date. That is a strict construction of the right to redeem in kind, but it is the right one because it is the one which is most consistent with the intentions of the parties when they entered into the investment agreement.
Assume, however, a slightly different factual scenario, where the Fund already owned an SPV at the time the redemption in kind was due for payment and was therefore able to accept the transfer of assets from an affiliated entity into this SPV after the date for payment had passed. Would that have been valid under the terms of the investment agreement? Or this scenario, where the Fund owned assets at the time when the redemption requests fell due which could only be transferred by hiving them into an SPV and issuing shares in the SPV to redeemers, but there was a delay in creating the SPV into which the assets were to be transferred. Would the Court have still held that the assets did not exist as at the relevant date, or would the Court have taken a different approach?
The judgment suggests that the answer to the first of these further questions ought to be yes, since the assets (the shares) would have been within the Fund's portfolio at the time when the payment in kind was due. However, the possibility should not be discounted that in such a case the Court might well seek to look through the SPV to see whether the assets which were transferred into the SPV were within the portfolio at the relevant time. The language of the relevant provision of the agreement relied upon by the Court of Appeal is broad enough to permit the Court to adopt such an approach, particularly if that approach is one which avoids the investor suffering a substantial loss immediately upon being paid in kind in circumstances where it appears that the Fund has acted arbitrarily or selected assets of uncertain value for distribution. Such approach is also consistent with the traditional creditor-friendly approach of the Cayman court.
The answer to the second question, applying the strict approach adopted by the Court of Appeal, would appear to be no: although the assets themselves do in fact exist within the Fund's portfolio, a failure to transfer them into the SPV in time appears to invalidate the distribution.
That may be an unfortunate and unintended consequence of the judgment, and may also suggest that the Court's focus on the time of the SPV's creation was a somewhat artificial means of achieving the right outcome in this particular case; the judgment should not perhaps be regarded as establishing a principle of general application in this regard. Nevertheless, a fund wishing to ensure that its redemptions in kind fall squarely within the bounds of the Court of Appeal's decision may be well advised to keep a few SPVs on hand for that purpose.
In respect of valuation issues, while this part of the Court of Appeal's decision was strictly obiter, it serves as a useful reminder to fund directors that their duties require them to adopt an approach which is reasonable and rational. Here it was clear to the Court that the directors had failed to do so: the decisions to allocate the relevant assets appeared to have been made in a hurry; asset valuations which were favourable to the Fund and detrimental to the Plans had been adopted, and such independent valuations were not contemporaneous with the decision to allocate those assets. Funds contemplating redemptions in kind would be well advised to ensure that, when it comes to valuing the assets they are proposing to transfer, an approach is adopted which is reasonable and appropriate to the relevant circumstances and that the decision making process is clearly recorded. Independent valuations will not be necessary in all cases, but funds are less likely to be criticized for commissioning them than failing to do so where there is reason to doubt what the present value of the asset is.