What Camulos, Matador and Strategic Turnaround Taught Us
There is little doubt that the face of the investment fund industry has changed significantly over the past two years. The statistics show, however, that whilst the industry has been impacted by the global economic crisis, like virtually every other industry, it has perhaps fared better than most and might well have been kinder to investors (Bernie Madoff type funds aside). In the financial crisis, hedge funds appear to have posed less systemic risk than other financial vehicles. 2009 marked the best annual fund performance in a decade according to sources such as Credit Suisse/Tremont Hedge Index and Hedge Fund Research, marking gains over the debacle of 2008.
The first half of 2010 saw an increase in the incorporation and registration of investment funds in the Cayman Islands, in spite of all the negative activity swirling around the industry. Cayman boasted 9000 funds in Q1. In January 2010 we saw 147 new fund authorisations and 58 terminations, compared to 106 authorisations and 39 terminations for January 2008.
It is perhaps a good time then to stop and take stock of the many lessons learned over the past two years. There were existing, but perhaps underutilized, provisions in the Articles of Association and the Offering Memorandum ( 'OM ') of funds that were dusted off and put to use, as well as new terms and provisions created out of necessity to allow funds to weather the storm. Gating, side pockets, suspensions, deferral of redemption payments and payments in kind, became common occurrences over a 2 year period. Every one of the aforementioned terms has in some form or other been dissected and analysed by the courts, both onshore and offshore, over the past two years. Out of this process, the courts have assisted in providing some certainty and guidance in relation to many of these provisions.
The reality behind the evolution of the investment fund industry however, as a result of the volatile markets and the strenuous court battles, is that the relationship between the Investment Manager, the Directors and the investors has changed, perhaps forever.
The very provisions employed by the Directors and the Investment Managers to salvage the fund and to enable them to fight another day during a turbulent market, were perceived by some investors as detrimental to them as they tried to pull out from troubled funds. This was compounded by the further perception that the Directors and Investment Manager might be acting to the benefit of more favoured investors with the implementation of Side Letters that were not disclosed to the other investors. Or worse, the perception that the Investment Manager and Directors might be motivated by self preservation and acting in their own best interests. This is a particularly challenging perception given the fiduciary obligations of the Directors to the fund and its investors whilst weighing the fact that the Investment Manager who set up the fund, typically holds the voting shares and appoints the Directors to the Fund.
Along the way however, and fast forward to 2009/2010, the investor has in general become more sophisticated with hard learned lessons. The emergence of consulting companies whose mandate is to advise the investor before he enters into a fund, to conduct due diligence on the fund and/or negotiate the provisions of the fund for the benefit of the investor, has rapidly changed the terms of the relationship of the parties involved with the fund right from the start. It could be argued that it has created a virtually contentious, at worst, and cynical, at best, relationship from the outset amongst the Investment Managers and the Directors on the one hand and the investors on the other. This notwithstanding that the very survival and well being of each is very much dependent on the other.
Deutsche Bank's newest survey of the hedge fund industry says the money is rolling in again - but not to funds that treated their investors shabbily during the hardship years of 2008 and 2009. The survey shows that some $22 billion to $100 billion could flow into hedge funds this year bringing sagging fund assets back to former highs at $1.2 billion, "but investors plan to shun those that locked up their money, froze assets or added so-called side pockets, where bad assets go to die a slow death".
According to the report, 80% of investors will refuse to invest in funds that participated in "freezing or suspending of assets and increasing side pockets by managers". Freezing of assets was voted as "the most damaging action to a fund's reputation" according to 38% of the respondents - a crime worse than bad performance which only took 20% of the votes.
Whilst the fund industry might be fighting the stigma by implementing more favourable terms for investors, it is also very clear that Investment Managers and Directors who establish funds moving forward must also now anticipate and accommodate for the new and improved sophisticated investor. The employment of an ' independent director ' to the fund, independent external valuation agents to value illiquid assets on a periodic basis, along with the adherence to the latest ' best practice principles ' for the industry as advocated by AIMA, might go a long way to instilling greater confidence in the investor. Nothing however, is more important than the drafting and detail of information provided to the investors in the OM and the Articles of Association ( 'Articles ' ) of the investment fund company.
As Cayman Islands lawyers we take the view that, from the outset, it is necessary that all the tools and provisions are made available to the Directors and the Investment Manager in the Articles and in the OM. The final decision as to how those terms and general provisions of the OM and Articles will be implemented for the benefit of the fund will depend, in large part, on the good judgment, skills and expertise of the Directors and the Investment Manager of the fund. It is imperative that the lawyer engaged and charged with this responsibility has sufficient experience and expertise to cover from the inception of the fund. In clearly and adequately outlining such provisions in the OM and the Articles, the information is not only available to assist the Directors and the Investment Manager in meeting all the needs and challenges of the fund during the life of the fund, but it will also be available for the investors to make a fully informed decision when investing from the outset. Adequate and continuous information to the investor during the life of the fund is crucial and might prove beneficial not only to the investor but to the Directors in order to prevent liability. All of this may well assist in managing expectations of the investor and in maintaining the relationship amongst all the parties, during the good times and the bad.
The judgments that have emerged out of the Cayman Courts, particularly over the past two years, has assisted the Cayman lawyer with the evolution of the drafting of Articles and the OM. This will ultimately better assist the Directors and the Investment Manager in providing effective stewardship, even during volatile market conditions.
Some of those judgments are worth mentioning here such as Strategic Turnaround Master Partnership, Limited in 2008 ("Strategic Turnaround"), which identified a five stage process by which redemptions are completed. The entire cycle of the redemption process was outlined to include:
- The notice to redeem;
- The debt that arises on the relevant Redemption Date;
- The valuation of the NAV at the Redemption Date and as a
consequence, the redemption sum;
- The payment of the redemption sum; and
- The removal of the Member from the Register.
In Strategic Turnaround the Court of Appeal noted that the exercise of the specific powers in the Articles to suspend the determination of the NAV, the redemption of shares and the payment of of redemption proceeds, was imposed by resolution of the directors, made after the notice to redeem had been served on the fund but before the redemption proceeds were paid to the investor and its name removed from the Register of Members. The court held that, as a result, the exercise of the power to suspend the payment of proceeds was an effective and valid suspension of the entire redemption process in respect of that investor. The investor became a creditor on the relevant redemption date of a future debt but remained a member of the fund until the redemption process was completed and so, as a member, was bound by valid resolutions of the directors.
The necessity of the dovetailing of the OM and the Articles of Association is often underestimated and overlooked. It is critical to the fund that these two documents expressly and accurately articulate the intended operation of the fund. The Court of Appeal in Strategic Turnaround made clear that the judgment related to the question of construction of the fund's articles, its OM and matters of law. In the Matter of the Companies Law (2007 Revision) (As Amended) and in the Matter of Matador Investments Ltd("Matador"), the Grand Court, distinguished the circumstances of the subject fund from those of Strategic Turnaround. The Matador funds Articles and OM, which provided for a power to suspend redemptions, failed to include a power to suspendthe right to receive redemption proceeds. Therefore the fund was unable to justify the non-payment of the redemption request in full to the redeeming shareholder once the redemption date passed and a payment demand was made. The investor was as a result able to successfully demonstrate that the fund had failed to and was unable to pay its debts as set out in the Law as a ground to petition the court for a winding-up of the fund. The Matador fund had been very much reliant on the provisions in its OM and Articles that facilitated a suspension of redemptions, calculation of NAV and the power to include gating provisions but had failed to include a provision to suspend the redemption payment also. The consequence was an order by the court for the winding up of the fund. Matador underscored the need to ensure that the drafting of the OM and the Articles is comprehensive, including the power to suspend all aspects of the redemption process as identified by Justice Vos JA in Strategic Turnaround.
The BVI Commercial Courts decision in Western Union International Limited vs Reserve International Liquidity Fund Ltd ('Reserve Fund') February 2010, addressed the redemption process and the point in time at which a redeeming shareholder becomes a creditor and ceases to be a shareholder of a fund. The Court however appears to have failed to provide sufficient analysis to assist in fully understanding its conclusions. The BVI Commercial Court also failed to make any mention of the Court of Appeal decision in Strategic Turnaround and the Reserve Fund decision is now currently being appealed.
The courts have also long wrestled and contended with the perceived predicament of the investor who might take the view that the best resolution for any dispute that he might have with the Directors of the fund, is to improperly force a resolution with the Directors by a petition to wind up the fund. The investor might pursue winding up notwithstanding that this is might not be what the investor actually wants and might well even be contrary to his own interests and to the interests of the majority investors. The ability of the investor to seek to wind up the fund on the 'just and equitable' ground was explored in great detail in both Strategic Turnaround and Camulos Partners Offshore Limited v Kathrein & Co 2010 ("Camulos Case"), another Court of Appeal case. Camulos addressed the new Sec 95 (3) of the Companies Law 2009 in respect of oppressed or prejudiced minority shareholders. Camulos agreed with Justice Vos JA's analysis in Strategic Turnaround of the then pending Sec 95 (3) statutory provision when he stated: "it will allow a statutory remedy for minority shareholders by, for example, ordering the purchase of shares, but it will do so in the context of a contributories 'just and equitable petition': there will, even then be no free standing unfair prejudice petition in the Cayman Islands".
Camulos went further to outline and detail what questions a court should take into account when a petition is filed with the courts to wind up a fund under Sec 95 (3) of the Companies Law (2009): (i) whether there is an alternative remedy available to the petitioner and (ii) whether the petitioner is acting unreasonably in not pursuing that alternative remedy. If a court is satisfied that both of those questions should be answered in the affirmative, then it can be expected to take the view that the presentation of the petition is an abuse of its process; alternatively, that the petition is bound to fail because it would not, in those circumstances, be just and equitable that the company be wound up. The Court of Appeal in Camulos held that in that instance the investors pursuit of winding up of the fund was unreasonable and an abuse of the Court's process and struck out the proceedings.
The predicament of the fund in general however, is whether or not there are just and equitable grounds, and whether or not it is in the best interests of the investor or the other investors to seek such a petition to the court. The process can be highly damaging and in some instances lead to a snowball effect of ultimately causing the collapse of an otherwise viable and solvent fund by triggering panic in other investors who may become aware of the petition by the investor.
As a firm, we have provided general advice to our clients to include a provision in the OM, the Articles and the subscription agreement by which the investors contractually agree not to petition the winding up of the fund, as is allowed under the 2009 revision of the Companies Law. This should, it is hoped, go a long way to ensuring that disgruntled investors do not try to use the winding up provisions to improperly force a resolution of disputed debts or other contentious issues through the courts and put inappropriate pressure on a fund. This, it is also hoped, will persuade such investors to utilize more appropriate and alternative remedies available to them.
The relationship between the parties to a fund need not spiral out of control to the detriment of all, including the investors, if the process is well thought through to cover as many eventualities as is possible. The investment by the Directors and the Investment Manager in the preparation of the OM and the Articles by lawyers who are experienced to guide the Directors and the Investment Manager through the foundations of the fund, might prove to be invaluable. Invaluable in saving not only the economic position, but also the relationship of the parties, during the good times and the bad.
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.