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.
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.
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:
- 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.
- 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.
- 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.
- 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.
- 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:
- 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.
- 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".
- 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 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 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.
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.
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.