Plenty of ink has been spilled following the ruling of the Cayman Islands Court of Appeal on 18 November 2016 in the Weavering preference case SEB v Conway and Walker. The case is of obvious interest to insolvency experts, but it is also of wider relevance, highlighting the binding nature of a fund's net asset value, and the risks of serving as a custodian or nominee investor for an underlying client. The facts of Weavering are now notorious. In short, an open-ended Cayman Islands investment fund (whose controlling mind was United Kingdom-based investment manager Magnus Peterson, and whose directors were Magnus' brother and father-in law) defrauded its investors by painting a picture of positive growth using worthless swaps with an affiliated company, and causing net asset values to be calculated on fictitious unrealised gains from the swaps.
The reality was that Weavering was making huge losses through options trading, masked by the swaps and spending significant sums on management and performance fees. Swedish bank SEB (Skandinaviska Enskilda Banken), which was acting as custodian or nominee investor for third parties, redeemed its shares shortly before the fraud was uncovered, and received redemption proceeds based on the fictitious net asset values. Weavering's Cayman Islands liquidators sued SEB for the return of the redemption payments on the basis that they were voidable preferences under the relevant Cayman Islands legislation.
The Court of Appeal's decision has attracted much attention because it is a rare example of Cayman Islands or BVI liquidators bringing a successful clawback action. Other recent high-profile clawback attempts, including by the liquidators of the Fairfield Sentry and DD Growth funds, which were also funds brought down by frauds, failed unequivocally.
The requirements of preference claims under Cayman Islands law are considered to be challenging. They include proving cash flow insolvency of the payer at the time of the payment, and a dominant intention on the part of the payer to put the recipient in a better position than he would have been as an unpaid creditor in the subsequent liquidation.
The conclusions reached by the Court of Appeal on these points are of particular interest to insolvency practitioners.
In relation to the requirement for cash flow insolvency at the time of the relevant payment, it was held that the Cayman Islands' cash flow insolvency test could take into account debts that were to fall due in the 'reasonably near future' and did not have to be limited to the debts that were due and payable at the precise time the alleged preferential payment was made.
That conclusion is particularly notable because the Court of Appeal held that the socalled words of futurity, which have appeared in the English cash flow test of insolvency since 1985, but are not in the Cayman Islands test (namely that the company must be unable to pay its debts as they fall due), do not add anything of substance.
According to the Court of Appeal, with or without those words, the court is able to take into account future debts when considering cash flow insolvency. In reaching that decision, the Court of Appeal did not, however, refer to the seminal English case of Re Cheyne Finance (2008), which held to the contrary. Contrary to some views that have been expressed, it is doubtful whether this point represents a real change to the Cayman Islands Court's winding up jurisdiction (which includes the cash flow test of insolvency). Winding up a company which can pay today's debts but will not be able to pay future debts has always been possible – and remains possible – under the court's wide jurisdiction to wind up a company on just and equitable grounds.
The finding that Weavering made the payments to SEB with the 'dominant intention to prefer' SEB is perhaps the most unorthodox aspect of the Court of Appeal's decision. In the absence of a cogent explanation for the payments to SEB (for example to ward off threats of litigation), the court appears to have inferred that the dominant intention had been to improve the position of SEB.
SEB intends to appeal to the Privy Council, so these key points are likely to be revisited soon. In the meantime, however, it is doubtful that the Court of Appeal's decision will see a flood of new preference claims brought by Cayman Islands liquidators in the investment funds arena. This is because it is still extremely rare for an investment fund to become technically insolvent, even where it is the subject of formal liquidation proceedings. A fund's constitutional documents contain various safety mechanisms to help prudent and honest directors and managers prevent that eventuality arising. And also because the facts of Weavering itself were extreme – Peterson is currently in jail in the UK as a result of the fraud that was perpetrated.
The net asset value is binding
Investment funds will welcome the Court of Appeal's emphasis on the binding nature of the net asset value struck by Weavering and the importance of commercial certainty in the investment funds marketplace. SEB had sought to argue that Weavering's debts to redeemed investors were not really debts at all because they were based on fictitious net asset values; therefore Weavering could not be said to be cash flow insolvent at the relevant time, and therefore the liquidators could not meet the requirements of a preference. The Court of Appeal firmly rejected the notion that the net asset value struck was not binding, despite the fact that it had been struck on a fictitious basis.
The Court of Appeal placed significant weight on the fact that Weavering's constitutional documents expressed the net asset value to be binding on all persons and to revisit it with the benefit of hindsight would not be a practicable or permissible approach.
The Privy Council had reached the same conclusion in the Fairfield Sentry case in 2014, which concerned a collapsed BVI fund that had innocently invested in a fraudulent Madoffcontrolled vehicle. SEB sought to argue that the position in Fairfield Sentry (where the fraud had taken place within one of the fund's underlying investments) had been different to that in Weavering (where the fraud took place within the fund). The Court of Appeal was not persuaded to draw that distinction emphasising that any other conclusion would be commercially unworkable for investment funds.
The roles and risk of the Custodian
The Court of Appeal's ruling serves as an important reminder of the risks inherent in acting as custodian or nominee investor.
SEB was at pains to stress that it was 'only' a custodian and that the redemption payments it had received from Weavering had been passed on to the underlying investors who had the economic interest in Weavering's performance.
SEB noted that had the liquidators based their clawback claim on the law of mistake, SEB would have had a number of possible equitable defences available to it, including the defence of 'change of position' which could have been invoked by the fact that SEB had passed the redemption proceeds on to the underlying investors and could not now get them back.
SEB argued that that suite of defences was available to it in a preference claim too. That argument was rejected by the Court of Appeal, which found that there was no room for those types of defences in the statutory preference provisions.
It therefore continues to be the case that in a statutory preference claim, the knowledge, intention or position of the recipient is irrelevant. The policy underpinning the preference legislation is to ensure rateable treatment among the general body of unsecured creditors This trumped any unfairness caused by an innocent recipient having to return a redemption payment and then line up with the other unpaid unsecured creditors for a dividend in the liquidation. The Court of Appeal noted that the indemnities SEB had obtained from its underlying clients were now, unfortunately for it, worthless. Through no fault of its own, SEB was left carrying the litigation cost and risk itself as a cost of doing business.
Custodians are of course often dragged into litigation as claimants where the underlying beneficial shareholder wishes to pursue claims against the company or a third party. In those circumstances, custodians are able to think in real time about the business risks they face and discuss them with the underlying investor.
From a reputational perspective, are they willing to lend their names to a lawsuit? Are they comfortable authorising the underlying beneficial investor to swear evidence and file other court documents on their behalf and in their name, and will the authorisation process be a one off process or continuous? Are they being appropriately remunerated and protected from potential liability by the underlying investor? If any concerns cannot be addressed with the underlying investor, there is usually time to make alternative arrangements, such as transferring the shares to another custodian or to the underlying investor to hold directly.
But this type of real time risk management cannot easily be undertaken to mitigate the risk of preference claims. As SEB found out, having contractual indemnity rights against the underlying investor does not eliminate the custodian's risk because preference claims are often brought many months, if not years, after the relevant payment has been made by which time the underlying investor may not have the means to satisfy a call on the indemnity, or may itself have been wound up.
So in conclusion, the Weavering clawback case is instructive on many different fronts: a rare and somewhat unorthodox clawback success for liquidators; a further emphasis on the binding nature of an investment fund's net asset value; and an important reminder about the perils of serving as custodian. It remains to be seen what the Privy Council will have to say about these issues.
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.