A recent judgment of the Cayman Islands Court of Appeal has provided certainty for directors, general partners and insolvency practitioners with respect to the principles that the Cayman Islands Courts will take into account in determining whether to grant a validation order in the context of Cayman Islands winding up proceedings. This article provides an overview of validation orders in Cayman Islands insolvency proceedings and a summary of the relevant factors to consider when making an application seeking a validation order.
Under Cayman Islands law, if a winding up order is made, the winding up of a company is deemed to commence at the time of the presentation of the winding up petition for an official liquidation or the passing of the members' resolution in the event that a Court supervised liquidation commenced as a voluntary liquidation. 1 There will inevitably be a period of time that passes between the commencement of the winding up and the making of a winding up order. As such, a question often arises as to whether a company that is the subject of winding up proceedings can enter into valid transactions during that intervening period in circumstances where a winding up order is ultimately made by the Grand Court of the Cayman Islands (the 'Grand Court').
The answer can be found in section 99 of the Companies Law (2018 Revision) (the 'Companies Law'), which provides that:
'When a winding up order has been made, any disposition of the company's property and any transfer of shares or alteration in the status of the company's members made after the commencement of the winding up is, unless the Court otherwise orders, void.'
The requirements for obtaining a validation order (which can be sought either in advance or retrospectively) were recently considered and reaffirmed by the Cayman Islands Court of Appeal ('CICA') in In Re Torchlight Fund L.P. (Unreported, 27 April 2018, CICA). This article provides an overview of validation orders in Cayman Islands insolvency proceedings and summarises the applicable principles that the Grand Court will consider in determining whether to grant a validation order.
Purpose of Section 99
Pursuant to section 99 of the Companies Law, any disposition of the company's property, effects and things in action, or any transfer of shares held by the company and/or in the company or alteration in the status of the members of the company during the period between the commencement of the winding up and the making of the winding up order is void, unless the Grand Court grants a validation order. It follows that in the event that a winding up petition is dismissed and therefore no winding up order is made, section 99 will not affect a transaction entered into following the presentation of such winding up petition (although noting that the relevant transaction could potentially be successfully challenged by a liquidator in the future pursuant to an alternative antecedent transaction section of the Companies Law should a winding up order be granted on a further winding up petition2).
Section 99 seeks to void any transfer of a company's property which would have the result of diminishing the 'pot' of assets available for distribution to the company's stakeholders in a liquidation. Section 99 also assists in protecting the fundamental principle of pari passu treatment of all unsecured creditors, that is, the principle that all unsecured creditors equally share in any available assets in the insolvent estate according to their rights and interests in the company. If a transaction is void pursuant to section 99, the liquidator will be entitled to seek appropriate relief for any asset to be returned or repayment of funds for the benefit of the company's creditors as a whole.
The exception to section 99
The legal rights of a secured creditor will be unaffected by the commencement of winding up proceedings of a company.3 Accordingly, irrespective of the existence of section 99 of the Companies Law and any insolvency proceedings on foot, a secured creditor will retain the ability to enforce its security and sell the charged property to obtain payment of the debt owing without leave of the Grand Court and without reference to any liquidator. If the sale proceeds of the charged asset are insufficient to discharge the debt, a secured creditor can rank as an unsecured creditor in the liquidation in respect of the balance of the debt.
A secured creditor may appoint a receiver over a charged asset for the purpose of enforcing their security rights if permitted by the relevant security document. A receiver is not subject to supervision by the Grand Court and their primary duty will be to the secured creditor, as opposed to the general body of creditors. Despite the fact that a receiver's primary duty is to the secured creditor appointing it, the receiver is an agent of the company. As such, the receiver also owes duties to the company, in particular, a receiver must act in good faith, must deal fairly and equitably with the company and, if selling an asset, owes a duty to the company to obtain the best price reasonably available in the circumstances.
Should a secured lender enter into a new security arrangement with a company after the commencement of winding up proceedings against such company, that security is likely to be void (if not validated by the Grand Court) where a winding up order is granted. Therefore, prior to taking any security, a secured lender should make certain that no winding up petition has been presented against the company by undertaking a search at the Grand Court. A secured lender should also ensure that an appropriate special resolution placing the company into voluntary liquidation has not been passed by the members in general meeting, and, in respect of a limited duration company, that a triggering event has not occurred: a security document executed by the directors of the company after a voluntary winding up has been commenced without the consent of the liquidators or the members of the company is likely to be void unless ratified.
Transfers of shares pursuant to section 99
Following the decision of Smellie C.J. in In re Bayou Offshore Master Fund Limited [2007 CILR 434], it is typical for applications seeking the validation of a transfer of shares in a Cayman company in liquidation to be dealt with by the Grand Court administratively, that is, without the need to attend an oral hearing before the Grand Court. In Re Bayou, which involved the transfer of shares in a Cayman Islands mutual fund which was in liquidation, Smellie C.J., stated that 'in order to save the costs of what are anticipated to be routine applications, any such application may be made in writing and may be considered administratively by a judge.'
The historical rationale for the prohibition on a transfer of shares relates to the obligation on the members of a company to contribute to the assets of the company, limited to the par value (particularly in the context of an investment fund). However, it is more common now for shares to be issued as fully paid or with nominal par value. Accordingly, the Grand Court recognises that a transfer of fully paid shares should generally be validated on an administrative basis.4 The Grand Court is also familiar with applications made pursuant to section 99 to facilitate the market for buying and selling shares held in Cayman Islands companies in official liquidation proceedings.
Order 19 of the Companies Winding Up Rules 2018 expressly addresses applications made pursuant to section 99 of the Companies Law seeking a validation order for the transfer of shares in companies in liquidation. It provides that where an application is made pursuant to Section 99 'for an order validating the transfer or proposed transfer of any shares of a company may be made by its liquidator or by the transferor or transferee of the shares in question' and 'provided that the shares in question are fully paid and the liquidator does not object to the transfer, the application shall be made by a letter addressed to the Judge to whom the proceeding is assigned.' Such an application 'shall be supported by an affidavit, confirming that the shares are fully paid and that the liquidator has no objection to the transfer, and a draft of the order sought by the applicant'.
In circumstances where those prerequisites cannot be met, a substantive application would need to be made and heard orally before the assigned judge in the liquidation proceedings.
What will the Grand Court consider on the application for a validation order?
The Companies Law does not prescribe the circumstances in which the Grand Court may validate any particular disposition; the Grand Court's discretion pursuant to section 99 is unfettered. That said, guidance on the principles to be taken into account by the Grand Court when considering whether to grant a validation order under section 99 can be derived from case law, and different considerations may apply depending on whether the company concerned is solvent or insolvent.
In relation to solvent companies, the recent decision of the CICA in Aurora Funds Management Limited et al v Torchlight GP Limited (Unreported, Morrison JA, 27 April 2018) reaffirmed the principles which the Grand Court will take into account in determining whether to grant a validation order. The CICA cited the dicta of Henderson J. in In Re Fortuna Development Corporation [2004-2005] CILR 533 in which the Grand Court held that 'there are four elements which must be established before an applicant is entitled to a validation order...'. These are:
- the disposition must be within the powers of the directors;
- there must be evidence to show that the directors believe the disposition is necessary or expedient in the interests of the company;
- the directors must have reached that decision in good faith; and
- the reasons for the disposition must be shown to be ones which an intelligent and honest director could reasonably hold.
In Re Fortuna Development Corporation, Henderson J. added that the test the applicant must satisfy is not high but there must be a body of evidence which, viewed objectively, establishes that the decision is one which a reasonable director, having only the best interests of the company in mind, might endorse.
The CICA also cited In Re Cybervest Fund  CILR 80, in which Smellie C.J. agreed with and adopted the guidelines set out in Re Fortuna Development Corporation, but added that the Grand Court should also consider whether irregularities in the conduct of the affairs of the company can be shown, even if the company is clearly solvent.
In Re Cybervest Fund, it was alleged that there had been a deliberate attempt by the fund managers to divert the company's assets for their own purposes and that the substratum of the company had failed. Smellie C.J. declined to make a validation order in that case on the basis that he did not consider that 'the directors could properly hold that these dispositions are necessary or expedient in the interests of the company at this time'. The Torchlight case also concerned alleged irregularities in the conduct of the affairs of the exempted limited partnership which went to the very heart of the question as to whether a validation order be granted in the circumstances.
In relation to insolvent companies, the principal concern of the Grand Court in considering an application for a validation order will be to seek to avoid prejudice to the interests of unsecured creditors of the company (In the Matter of Freerider Limited [2010 (2) CILR 154, citing the decision of the English Court of Appeal in Denney v John Hudson & Co Ltd  BCC 503). Generally speaking, available assets of an insolvent company will be distributed to unsecured creditors on a pari passu basis, meaning that all creditors will share equally in such assets in proportion to the debt due to each creditor.
In Express Electrical Distributors Ltd v Beavis and others  EWCA Civ 765, the English Court of Appeal considered and reaffirmed the English decision of Re Gray's Inn Construction Co Ltd  1 WLR 711 which held that save in exceptional circumstances, a validation order should only be made in respect of an insolvent company if there is some special circumstance which shows that the disposition in question will be (in a prospective application case) or has been (in a retrospective application case) for the benefit of the general body of unsecured creditors, such that it is appropriate to disapply the usual pari passu principle. The English Court of Appeal in Express Electrical Distributors Ltd however rejected the long held position following Re Gray's Inn that a disposition carried out in good faith in the ordinary course of business at a time when the parties were unaware that a winding up petition had been presented should normally be validated by the court, noting that validation on such basis could well prejudice the interests of the body of unsecured creditors. The judgment serves as a reminder that those seeking validation orders to continue trading, or for specific creditors to be paid, must produce clear and credible evidence that the payment will, or did, produce a benefit to the general body of creditors. This decision, though not technically binding, would be regarded as persuasive to the Grand Court.
The interests of the creditors of a company in liquidation are paramount. In line with this fundamental principle, section 99 of the Companies Law provides protection for unsecured creditors of a company that is subsequently wound up. It has long been established that, in the case of an insolvent company, a validation order, which will disapply the usual pari passu principle, should only be made in exceptional circumstances which demonstrate that the disposition is of benefit to the general body of creditors. Recent authorities suggest that it is now no longer sufficient that payments made in good faith and in the ordinary course of business without knowledge of the winding up proceedings will result in a validation order. As such, counterparties should closely monitor trading relationships regularly in an attempt to avoid issues with companies in financial difficulties given the potential for payments needing to be repaid to an insolvent estate in the absence of exceptional circumstances
1 Section 100 of the Companies Law.
2 Section 145 of the Companies Law (Voidable preferences), section 146 of the Companies Law (Avoidance of dispositions made at an undervalue) and section 147 of the Companies Law (Fraudulent Trading).
3 Section 142 of the Companies Law.
4 Order 19, rules 4 and 5 of the Companies Winding Up Rules 2018.
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.