A recent judgment of the Cayman Islands Court of Appeal1 (CICA) has over-turned an earlier decision of the Grand Court of the Cayman Islands (Grand Court) which had conferred the power on an official liquidator to adjust the rights of shareholders, in the winding up of a Cayman Islands investment fund, where the rights of shareholders have been distorted by the effects of a pervasive, but external fraud. Unfortunately for shareholders whose net asset values (NAVs) have been adversely affected by such a fraud, based on the current state of the law (as referenced in the CICA's judgment) it would appear that the toolbox is bare, despite the best intentions of the draftsman.

The CICA decision is the most recent in the ongoing liquidation proceedings of Herald Fund SPC (in Official Liquidation) (Herald), a segregated portfolio company incorporated in the Cayman Islands which was one of the largest so-called feeder funds into the Madoff Ponzi scheme.

This aspect of the proceedings involved an important point of statutory construction, namely whether an official liquidator has a statutory power under section 112(2) of the Companies Law and its subordinate legislation to rectify (or, in other words, adjust) a share register so as to override the contractual rights of investors in the winding up of a Cayman Islands investment fund. Notwithstanding that this power has been exercised previously by official liquidators on at least one occasion (of which we are aware) in very similar factual circumstances without opposition, this was the first time the question of its scope and application had confronted the Grand Court and the CICA.


Herald was incorporated in the Cayman Islands in 2004 as a segregated portfolio company and was one of the largest so-called feeder funds into the Madoff Ponzi scheme (having invested all or substantially all of its assets in the Madoff Ponzi scheme since its inception in 2004). When Madoff was arrested on 11 December 2008, Herald's business effectively collapsed overnight and its directors focused their attention, with the assistance of lawyers in various jurisdictions, on recovering its assets through litigation. Some years later, following the presentation of a winding up petition by Herald's largest investor, Primeo Fund (in Official Liquidation) (Primeo), Herald was placed into official liquidation in July 2013.

Herald's principal asset is its claim in the United States bankruptcy of Bernard L. Madoff Investment Securities LLC (BLMIS), which has been admitted in the amount of approximately US$1.6 billion (less a substantive "clawback" payment) – significantly less than the circa US$2 billion recorded as being held in Herald's managed account with BLMIS prior to the discovery of the Madoff fraud. Given the hopelessly co-mingled nature of the fictitious managed account purportedly operated by BLMIS (which was, in effect, the world's largest Ponzi scheme), the Trustee of the BLMIS bankruptcy has, in accordance with US legal principles, determined claims in the bankruptcy by reference to the investors' individual net cash investment in BLMIS using what has been termed the "Net Investment Method" (that is, total cash invested less total amounts withdrawn prior to the collapse of BLMIS). The real value of Herald's claim in the bankruptcy of BLMIS is currently estimated to be in the vicinity of US$750 million - US$800 million.

Further complicating matters, in May 2007 Primeo, which was already a shareholder of Herald, subscribed for further shares in Herald, the consideration for which was the in specie transfer to Herald of the assets purportedly held in Primeo's managed account with BLMIS. At the time, those assets had a notional value of approximately US$463 million. Pursuant to that subscription, Primeo was duly issued shares in Herald at the prevailing NAV per share based on the value of its managed account with BLMIS (approximately US$463 million). However, as a result of the application of the Net Investment Method by the BLMIS Trustee, the component of Herald's claim in the BLMIS bankruptcy attributable to the in specie transfer from Primeo has been valued at approximately US$149 million (i.e. approximately one third of the notional or face value). It was the substantially lower $149 million figure which was used by the BLMIS Trustee in calculating Herald's admitted claim which, in turn, formed the basis of distributions received by the Liquidators for onward distribution to investors.

The issue facing the Additional Liquidator

Essentiality, the issue facing the Additional Liquidator was one of injustice, and how best to correct that, to the extent possible, in the distribution of the available surplus in Herald's liquidation to its continuing members.

As a result of the massive fraud perpetrated by Madoff, all of Herald's shareholders recorded on its share register as at the commencement of liquidation have suffered a "common misfortune" in that the notional value of their investment in Herald has been lost. Save for Herald's initial subscription price of US$1,000/€1,000 per share, every NAV per share at which investors subscribed for or redeemed shares in Herald during its operative life was wholly mis-stated (Herald's NAV having effectively been based solely on fictitious account statements received from BLMIS which reflected steady increases month on month). This created a situation where a large number of investors' shareholdings in Herald bear no reference to their net cash invested in Herald, but rather represent fictitious profit purportedly generated through Herald's investment in BLMIS.

If the net surplus available for distribution in the liquidation of Herald was to be distributed to shareholders pursuant to ordinary principles (i.e. a pro-rata distribution based on their recorded shareholdings as at the commencement of the liquidation), this would have the effect of perpetuating Madoff's fraud through the liquidation, with those shareholders who redeemed shares equivalent to most if not all of their total cash subscription pre-liquidation (due to the increasing NAV per share, which is now known to be wholly fictitious) benefiting at the expense of those shareholders who redeemed shares equivalent to a small percentage of their total cash subscription or, indeed, those shareholders who did not redeem at all.

This inequality is further compounded by Primeo's in specie subscription, which has resulted in Primeo holding approximately US$300 million in shares as at the commencement of the liquidation (in addition to those other shares for which it actually paid cash in the ordinary way) for which no distribution from the BLMIS estate will be referable. Put another way, on any pro-rata distribution based on Primeo's shareholding as at the commencement of the liquidation of Herald, Primeo would be entitled to a materially greater proportion of Herald's recoveries from the BLMIS estate (at the expense of Herald's other shareholders who subscribed in cash) than it would if it had remained invested directly in BLMIS and had its own claim in the BLMIS bankruptcy (in which eventuality, Primeo would have very likely faced a separate "clawback" claim by the BLMIS Trustee under US bankruptcy law).

The Additional Liquidator's toolbox

In 2010, legislative amendments were introduced to the Companies Law and its subordinate legislation, the Companies Winding Up Rules 2008 (CWR)2, which the CICA quite rightly describes as having been intended "to effect a notable change in the law" which endeavoured to "provide a new course of action which liquidators could adopt when distributing surplus assets of funds which had issued redeemable shares" which had been subscribed for and/or redeemed at prices based upon NAVs which had been wholly mis-stated as a result of a pervasive fraud.

Section 112(2) of the Companies Law provides:

In the case of a solvent liquidation of a company which has issued redeemable shares at prices based upon its net asset value from time to time, the liquidator shall have power to settle and, if necessary rectify the company's register of members, thereby adjusting the rights of members amongst themselves.

One issue that confronted the Additional Liquidator was that in circumstances where there has been an "external" fraud affecting a company's NAV (i.e. the Madoff fraud), the Cayman Islands legislative regime provides little guidance on when a power to rectify may be exercised by an official liquidator and, if it is to be exercised, how it should be exercised.

Prior to the liquidation proceedings of Herald, section 112(2) had not been the subject of any judicial consideration in the Cayman Islands (of which the authors are aware), nor did it appear to have been taken from the companies or insolvency legislation of any other common law jurisdiction. Accordingly, the Additional Liquidator was effectively in the position of having to "break new ground" in assessing whether section 112(2) would operate so as to allow a more equitable distribution of the surplus assets. Ultimately, the Additional Liquidator sought directions from the Grand Court permitting him to rectify Herald's share register (that is, override the contractual rights of Herald's shareholders) so as to do substantial justice amongst Herald's shareholders in two material ways:

  • Rectify Herald's share register using the Net Investment Method3 or the Rising Tide Method4 in order to ameliorate the effects of the Madoff fraud and ensure the available surplus is distributed to Herald's shareholders as equitably as possible; and
  • Rectify Herald's share register so as to adjust Primeo's shareholding to reflect the real value of the consideration provided to Herald pursuant to the in specie subscription (approximately US$149 million), thereby ensuring Primeo would not receive more of the distributable surplus derived from the BLMIS estate than which the Additional Liquidator considered it to be entitled.

First instance decision

The existence of and exercise by an official liquidator of a power of rectification under section 112(2) was considered by the Grand Court in two separate hearings taking place in June 2015 and July 2016, respectively.5

Whilst the Grand Court found that the Additional Liquidator was not required to exercise his power of rectification, the Grand Court nonetheless found that section 112(2) created a free-standing power to override the contractual rights of the shareholders (i.e. rectify the share register) when necessary, in order to achieve substantial justice amongst the shareholders (but that the power was in the form of a class remedy, which did not extend to an individual adjustment of Primeo's shareholding as a result of its in specie subscription).

Further, the Grand Court found that in the circumstances of Herald's liquidation there "could be no clearer case" in which the power of rectification ought to be exercised by the Additional Liquidator, but appeared to place considerable importance on the concept of establishing "true NAV" for the purposes of exercising the power under section 112(2) of the Companies Law, rather than the broader concept of "overriding the contractual rights of shareholders so as to do substantial justice". The Grand Court directed the Additional Liquidator to treat the initial subscription price of US$1,000/€1,000 as the "true" NAV per share, rather than permitting the adoption of the Net Investment Method or Rising Tide method. However, it subsequently became apparent to the Additional Liquidator when theorising the potential implementation of the Grand Court's direction that it did in fact have precisely the same economic consequences as the Net Investment Method. The Grand Court's decision can therefore be seen as affirming the Additional Liquidator's proposed use of the tool provided by section 112(2) of the Companies Law to correct (as far as possible in the distribution of Herald's available surplus) the substantial injustice suffered by Herald's remaining shareholders as a result of the BLMIS fraud.

CICA decision - emptying the toolbox

Ultimately, despite being "troubled" by the injustice which would be suffered by a large number of Herald's shareholders in the distribution of its surplus assets in the event that Herald's share register was not rectified in a manner contended for by the Additional Liquidator, which the CICA described as "powerful and challenging considerations", the CICA (adopting a rather black-letter approach) overturned the decision of the Grand Court. In so doing, the CICA found that the power conferred on the Additional Liquidator by section 112(2) is limited to correcting an incorrect NAV in accordance with the contractual rights of shareholders rather than providing a discretionary power to interfere with shareholders' proprietary rights.

Despite the CICA remarking "it is clear that the legislature intended to effect a notable change in the law" in order to resolve "complex and novel problems", in circumstances where the articles of association of almost all Cayman Islands mutual funds provide that NAVs are binding as between a company and its shareholders in the absence of fraud or bad faith on the part of the company, the practical effect of the CICA's judgment (subject to any potential further appeal) is that an official liquidator no longer has any effective tools at his disposal to rectify a share register in order to correct substantial injustice where the NAVs at which shares have been issued and redeemed have been wholly mis-stated as a result of a pervasive fraud which is external to the company (as is typically the case).


Whilst the CICA's decision has provided some clarity - at least for the time being - as to the scope of what is plainly a bespoke legislative provision, it has removed what could have been (and, arguably, was intended to be) a very powerful equitable tool from an official liquidator's toolbox designed to do justice in the winding up of Cayman Islands domiciled investment funds affected by pervasive (albeit external) frauds. Section 112(2) of the Companies Law may well now be ripe for legislative reform in light of its very limited (or non-existent) practical application.

Matthew Goucke and Chris Keefe act for Mr Pearson, the Additional Liquidator of Herald.6


1 Primeo Fund (in Official Liquidation) v Michael Pearson (in his capacity as Additional Liquidator of Herald Fund SPC (in Official Liquidation)), unreported, 27 February 2018.

2 The CWR were replaced by the Companies Winding Up Rules, 2018 on 1 February 2018; however, the language of the relevant order (Order 12) remains the same.

3 The Net Investment Method proposed by the Additional Liquidator involved calculating each investor's economic interest in Herald on the basis of their individual net equity (total subscriptions less redemptions) as a percentage of the total pool of funds available for distribution.

4 The Rising Tide Method proposed by the Additional Liquidator involved an additional adjustment after the application of the Net Investment Method to take account of the quantum of redemptions received by an individual investor pre-liquidation, which would have the effect of ensuring that no investor recovered a greater percentage of their total capital contribution than any other investor (unless that investor had already received a greater percentage of their total capital contribution pre-liquidation than investors will otherwise receive from the liquidation itself).

5 Primeo Fund (in Official Liquidation) v Pearson [2015 (1) CILR 482] and In Re Herald Fund SPC (In Official Liquidation) FSD 27 of 2013 (unreported, 2 September 2016).

6 Together with Leading Counsel, Lord Goldsmith QC PC and Francis Tregear QC.

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