Cayman Islands: Implications Of Gottex Funds v Stewardship Credit Arbitrage Fund

Last Updated: 29 December 2008
Article by Jonathan Paul Tonge, Mark Lewis, Guy Locke, Ingrid Pierce and Nick Rogers

Most Read Contributor in Cayman Islands, September 2018

Introduction

The Supreme Court of Bermuda recently ruled in favour of investors in a hedge fund in BNY AIS Nominees Limited & Ors v Stewardship Credit Arbitrage Fund, Ltd. (the "Judgment") in circumstances in which the fund had purported to pay redemption proceeds in kind.

This Advisory considers the implications of the Judgment for the payment of redemptions in kind, including through the use of "synthetic" side pockets 1, by Cayman Islands and British Virgin Islands hedge funds. The Advisory makes recommendations for how existing funds should proceed when planning to pay out redemption proceeds in kind, and suggests issues to consider when drafting the documents for new funds.

Background

The Judgment, handed down by Bell J, describes the background of the case. In summary, certain shareholders (referred to as the "Gottex Funds") of Stewardship Credit Arbitrage Fund, Ltd. (the "Fund" or the "Company") served redemption requests on the Fund for the complete redemption of their shares, with an effective redemption date of 31 March 2008. Under the Fund's documents, this required the Fund to deliver redemption proceeds to the Gottex Funds equal to the value of the redemption price (as at 31 March 2008) on or before 12 May 2008.

The Fund's bye-laws gave the board of directors discretion to settle redemptions in kind by distributing assets of the Fund having a value equal to the relevant redemption price.

On 12 May 2008, the Fund tendered "Participation Notes" to the Gottex Funds purportedly in satisfaction of the redemption price (less a small amount of cash previously paid by the Fund to the Gottex Funds). While somewhat unclear from the Judgment, it appears that on 12 May 2008 the Fund declared a trust for the purpose of pooling assets (being a portfolio of loans) said to be referable to the Participation Notes, and that the Participation Notes evidenced beneficial ownership interests in such trust. The Participation Notes provided for payment to the holder upon receipt by the Fund of any payment of principal or interest on the underlying loans. Transfers of the Participation Notes were not permitted without the written consent of the Fund.

Summary of the Judgment in respect of the Redemption in Kind

In the Judge's view, the bye-law permitting redemptions to be settled in kind imposed three conditions: (i) the assets in question had to be "distributed", (ii) the assets to be distributed in kind had to be "assets of the Fund", and (iii) the assets to be distributed in kind had to be assets "having a value equal to the relevant Redemption Price".

The Judge considered that the tendering of the Participation Notes by the Fund to the Gottex Funds did not constitute an in kind distribution under the bye-laws for the following reasons:

  • it was "highly doubtful that the arrangements envisaged under the Participation Notes could properly be described as a distribution", on the basis that the Fund continued to hold the assets in question in trust for the Gottex Funds;
  • it was "highly doubtful that the Participation Notes [could] properly be described as assets of the Fund";
  • it was "highly doubtful that the Participation Notes [could] properly be described as assets of the Fund";
  • there was no value in the Participation Notes for two reasons: (i) the Participation Notes were not transferable or negotiable in any way; and (ii) there was only an expectation that, in due course, payments would be made to the Fund pursuant to the underlying loans which the Fund (as trustee) would then have an obligation to pass on to the Gottex Funds. As such, the Participation Notes were described as "no more than derivative instruments" created by the Fund; and
  • even if the Participation Notes constituted assets of the Fund, the Participation Notes could not have a value equal to the redemption price.

Analysis

It must be noted that the case concerned a Bermuda fund, and while the principles of Bermuda law may be similar to Cayman and/or BVI law in certain respects, Walkers does not advise on Bermuda law and there may be differences which are relevant to the Judgment. In addition, we have not had the benefit of reviewing the documents referred to in the Judgment or the detailed arguments made before the court.

However, we note the following points in respect of the Judgment:

  1. The Judge gave no reason for his doubts about whether the Participation Notes constituted assets of the Fund, and the manner of creation of the Participation Notes is not clear from the Judgment. However, the Participation Notes appear substantially different in nature from shares in a special purpose vehicle which would more normally be distributed as a synthetic side pocket, and we can see why the status of the Participation Notes was challenged. In any event, even if the Judge's finding that the Participation Notes were not assets of the Fund is correct, that does not mean that the Judgment is authority that distribution of interests in a newly created vehicle is ineffective. This is discussed further below.
  2. The Judge opined that the Participation Notes had no value when tendered, based in part on the fact that they were not generally transferable or negotiable. In our view it does not follow that if a security is not readily transferable it is automatically worthless. If this were correct then all non-transferable securities would be ascribed a zero value, which does not accord with industry practice or accounting principles.
  3. A fund's documents invariably provide for the manner of valuing securities of the fund. In the absence of legal or regulatory requirements to the contrary, a fund and its investors are free to agree the valuation provisions that will apply without any requirement to mark to market, for example.
  4. The Judge also stated that the Participating Notes had no value at the transfer date because there was only an expectation that, in due course, payments would be made to the Fund which the Fund would then have an obligation to pass on to the Gottex Funds. Again, unless a fund's documents provide otherwise, we do not consider that securities which represent only some potential gain necessarily have no current value.
  5. The case was brought in the wider context of a debt action accompanied by a request for appointment of provisional liquidators and a just and equitable winding up of the Company. The ruling in relation to redemptions in kind was not the primary focus of the case, and the weight to be attached to the Judge's findings in this regard should be considered accordingly.

Implications for Cayman and BVI Hedge Funds

The comments below are general, and any advice in this area will of course be subject to the governing documents of the relevant fund and, if applicable, the terms of any synthetic side pocket arrangement it may implement.

There are a number of factors which make the case potentially distinguishable from the synthetic side pocket structures more commonly used by Cayman and BVI hedge funds:

  1. It is more usual for synthetic side pockets to be effected by the creation of a new special purpose vehicle ("SPV"), which issues shares to the fund in return for the fund's promise to pay the proceeds from the illiquid investments to the SPV. The shares issued by the SPV to the fund will constitute an asset of the fund, and it is these shares which are then transferred to the redeeming investors in kind.
  2. Assuming that the power exists in the fund's constitutional documents to distribute assets of the fund in kind, there is no reason to consider that the shares of the SPV held by the fund would not be capable of "distribution".
  3. It is common for the participation agreement entered into between the fund and the SPV to provide for the method of valuing the shares issued by the SPV, which may assist in refuting any argument that the shares have no value.

In addition, we note that the decision was at first instance (the lowest commercial court) in Bermuda and largely appears to have turned on the particular facts and circumstances of the case. The Judgment is not binding precedent for the Cayman and BVI courts, although it may have some persuasive value. It remains to be seen whether the Judgment will be appealed.

It may nonetheless be prudent for Cayman and BVI funds to take certain steps to minimise the risk of challenge.

New funds

New funds should consider building conventional side pocket mechanisms into their fund documents, and/or including robust disclosure relating to redemptions in kind. This may include specifying that the fund may distribute interests in a special purpose vehicle or other entity holding assets of the fund or holding entitlements to the proceeds of assets held by the fund, and confirming the method of valuing such interests. Language expressly permitting the fund to apply the valuation principles specified in the fund's offering document to any in kind distribution could be included.

To counter the risks associated with the potential reduction in value of the assets between the relevant redemption day and the date of the in kind distribution, it may also be advisable to specify in the fund's documents that, for the purpose of determining the value to be ascribed to any assets of the fund used for an in kind redemption, the value ascribed to such assets shall be the value of such assets on the relevant redemption day. The intention of such wording would be to ensure that the debt created upon redemption is fully discharged on the date of transfer even if the assets in question have declined in value in the period since the relevant redemption day.

Existing funds

Existing funds which are considering paying redemption proceeds in kind should carefully consider the terms of the fund's documents, and should ensure that the assets to be distributed are indeed assets of the fund. Securities issued by the fund are not assets of the fund. Care evidently needs to be taken if a trust arrangement is to be used. It is also advisable for the distribution on a redemption in kind to be made as soon as possible following the relevant redemption day, to minimise the effect of any reduction in value of the assets transferred. Where a synthetic side pocket is used, it may be appropriate to permit shares of the SPV to be transferred freely.

Existing funds should also pay careful attention to how and when the fund's assets are valued when calculating the net asset value (and therefore the redemption price) applicable to a redemption in respect of which an in kind distribution is to be made. If the illiquid assets are valued unrealistically for the purposes of calculating the NAV, that could lead to problems if the investors challenge the value of the distributed assets they have received. It is important to ensure that the basis of the valuation for the purposes of calculating the NAV is the same as the valuation methodology that would be applied if the investor sought an independent valuation of the shares or participation received. In some cases that may require a very low or nil valuation to be attributed to the illiquid assets.

Conclusion

This is an interesting case which examines a number of highly topical issues for distressed funds. The particular facts of the case differentiate it from the more commonly used synthetic side pocket solutions in the current environment. This distinction, and the fact that the Judgment is a decision of a lower Bermuda court, reduces the immediate significance of the case for Cayman and BVI hedge funds. However, there are particular actions that both existing and new funds could take to address some of the points raised in the Judgment.

Footnote

1 The term "synthetic side pocket" as used in this Advisory refers to an arrangement where (i) a fund holds non-transferable illiquid securities, (ii) the fund's documents permit it to pay out redemptions in kind but do not contain a traditional side pocket mechanism, (iii) an agreement is entered into between the fund and a newly formed vehicle pursuant to which, in consideration for the issue of interests by the vehicle to the fund, the fund agrees to pay to the vehicle the future proceeds from certain investments held by the fund, and (iv) the interests of the vehicle are distributed to redeeming investors as full or satisfaction of a redemption request, by way of a redemption in kind.

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
Some comments from our readers…
“The articles are extremely timely and highly applicable”
“I often find critical information not available elsewhere”
“As in-house counsel, Mondaq’s service is of great value”

Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions