Cayman Islands: Distributing Remaining Value In Liquidated Feeder Funds

The Grand Court of the Cayman Islands has determined how the remaining value in a liquidated feeder fund should be distributed amongst investors.

Introduction

On 2 September 2016, Mr Justice Andrew Jones QC delivered a landmark judgment, determining how the remaining value of a Cayman feeder fund in official liquidation should be distributed amongst its investors (Pearson v Primeo Fund¹

The case is the most recent chapter in the ongoing Primeo litigation² and provides valuable guidance to liquidators of Cayman feeder funds as to the scope of their power to facilitate an equitable distribution of value to investors.

Facts

Herald and Primeo were open-ended investment funds.  They both placed funds for investment with a Madoff-related entity called BLMIS. 

In 2007, Primeo assigned the credit of its account with BLMIS to Herald in return for subscribing for shares in Herald (the "In Specie Subscription").  The amount of Herald shares provided to Primeo was based on the perceived value of Primeo's account with BLMIS, which at that time was valued at US$466M. 

In 2008, it was discovered that BLMIS was a Ponzi scheme, with the consequence that every reported NAV had been misstated, including the NAV used to calculate the value of Primeo's consideration under the In Specie Subscription.

Herald was subsequently put into liquidation and its liquidator sought to determine how the remaining value in the fund should be distributed amongst its shareholders.  In particular, the liquidator was tasked with determining whether Primeo's shareholding in Herald should be adjusted to reflect the fact that it had received a greater number of shares in Primeo than it would have otherwise received if the actual value of its account with BLMIS had been known at the time of the In Specie Subscription.

The Court had previous decided³ that the liquidator had the power under section 112(2) of the Companies Law to rectify Herald's share register.  The issue before the Court in this instance was:

(a) whether Herald's share register should be rectified; and

(b)  if so, on what basis should any rectification be performed?

Decision

Should the register be rectified?

The Court began by noting that the concept of rectification under section 112(2) of the Companies Law implied restoring the register to a position that accurately reflected the relative position of all shareholders, as it would be if all subscriptions and redemptions had been transferred at a "true" NAV per share. 

Since every subscription and redemption of shares in Herald after the initial offering had occurred on the basis of a fraudulently misstated NAV, the Court found that there "could be no clearer case" in which the power of the liquidator under section 112(2) should be exercised.

However, Mr Justice Andrew Jones QC made it clear that section 112(2) did not confer any power on the liquidator to interfere with the proprietary rights of individual shareholders.  Section 112(2) is in the nature of a class remedy.  As such, any rectification needed to apply equally to all remaining shareholders. 

On what basis should rectification be performed?

The liquidator submitted that the register should be rectified, so that the net loss of subscription monies in Herald was borne rateably and the remaining shareholders shared equitably in the pool of funds available for distribution.  Two methods were proposed to achieve this.

Net Investment Method – This method calculates each shareholder's economic interest on the basis of the amount of their total subscriptions, less any redemptions, as a percentage of the total surplus funds available for distribution.  So long as the amount paid for a shareholder's total subscriptions exceeds the amount of their redemptions, they receive a pro rata share of any assets available for distribution.  However, this method favours those shareholders that have already received significant amounts of their capital contribution prior to redemptions being suspended, at the expense of investors that have redeemed smaller amounts.

For illustration purposes, in a hypothetical scenario where there is $5M available for distribution and four investors have subscribed for the same amount, but redeemed different amounts, the Net Investment Method would distribute the remaining funds as follows:

Rising Tide Method – This method directly takes account of redemptions that have already been paid to investors, in addition to the remaining value in the company.  It works by distributing remaining funds to shareholders, according to the value that each shareholder has already realised.   In effect, this means that shareholders that have redeemed less of their investment are paid in priority to those that have already received a larger return. 

When this method is applied to the same hypothetical scenario of distributing $5M to the four investors, the following allocations are made:

Mr Justice Andrew Jones QC saw merit in the Net Investment and Rising Tide methodologies, in that they would both create a result whereby Herald's shareholders could share in the common misfortune of Madoff's fraud.  However, he concluded that section 140(1) of the Companies Law prevented either method from being available. 

Section 140(1) requires the property of a company in liquidation to be distributed equally amongst its members according to their respective rights and interests.  The Court was of the view that rectifying the register in accordance either the Net Investment or Rising Tide methodologies would amount to lifting the corporate veil of Herald and treating the shareholders as if they were trust creditors having a proprietary claim against a co-mingled pool of assets, rather than shareholders with equal rights.  For this reason, the Court held that neither methodology was legally admissible.

Mr Justice Andrew Jones QC found that the proper approach was to assign a constant "true" NAV for each and every subscription and redemption throughout Herald's active life.  Since Herald's NAV had been fraudulently misstated since its inception, the "true" NAV was held to be the initial offering price of the shares.  All NAVs after this date needed to be disregarded, despite the value that may have actually been assigned (and paid) for shares at the time. 

The Court consequently directed the liquidator to recalculate each subscription and redemption of shares in Herald at this constant "true" NAV and rectify the share register accordingly.  Herald's shareholders would then participate in the distribution of Herald's property in the liquidation pro rata according to the size of their revised shareholdings.

How does this apply to Primeo's In Specie Subscription?

In most cases, the approach taken by Mr Justice Andrew Jones QC will produce similar economic results to the Net Investment Method.  However, this is not so in relation to in specie subscriptions.

Had the liquidator been able to apply either the Net Investment or Rising Tide methodologies, the size of Primeo's shareholding in Herald could have been adjusted based on the net amount of cash that Primeo had originally invested in BLMIS (US$150M).  However, based on the approach adopted by the Court, the size of Primeo's shareholding needed to be determined according to the (incorrectly) perceived value of the consideration that Primeo provided in the In Specie Subscription (ie US$466M).  It was irrelevant that this value had itself been calculated on the basis of a fraud by BLMIS.⁴

The liquidator was required to restate the number of shares which Primeo ought to have been issued under the In Specie Subscription in return for its consideration of US$466M at the "true" NAV.  Even though this approach would result in Primeo being allocated with a much greater number of shares and benefitting in the liquidation at the expense of other Herald shareholders, the Court made it clear that the power to rectify the register was for the benefit of the shareholders as a class and that the "true" NAV needed to be applied to all subscriptions and redemptions, including Primeo's In Specie Subscription.

Points of interest

The approach taken by the Cayman Court demonstrates the constraints that legislation can impose upon judicial decision-making.  Even if applying either the Net Investment or Rising Tide methodologies could have resulted in a more equitable outcome for Herald's shareholders as a whole, the Companies Law prevented the Court from being able to order rectification in accordance with either of these approaches.

In contrast, if Herald had not yet been put into liquidation, its directors may have had more freedom to apply a method that was more equitable to all shareholders.  Section 140(1) only applies in a liquidation context.  Whilst there is always an obligation to treat shareholders pari passu, directors of an active company have more freedom in working out what each investor's respective interest is before getting to the pari passu calculation (ie by reference to the company's articles of association and offering memoranda).

The Rising Tide Method is likely to achieve the greatest overall parity between shareholders; however, it can only be applied once the final amount available for distribution is known.  If shareholders wish to have their relative entitlements determined in advance of this being ascertained, the Net Investment Method could be applied.

A primary advantage of the approach taken by Mr Justice Andrew Jones QC is that the actual value exchanged for each subscription and redemption does not need to be identified.  Not needing to incur the expense of conducting such an investigation may leave a greater amount of funds available for ultimate distribution.  It would also protect investors who may have taken ownership of shares for less than their stated NAV (ie in a related party transaction) from being unduly penalised, as the actual consideration provided would be irrelevant to their entitlement.

Conclusion

Whilst the other Herald shareholders may feel aggrieved at Primeo being able to retain the benefit of the fraudulent NAV calculation under the In Specie Subscription, the Court's hands were effectively tied. The Net Investment and Rising Tide Methods were found to be legally inadmissible and inconsistent with the obligations imposed by the Companies Law.

The power of rectification must be applied equally to all shareholders and any method of distributing the remaining assets of a company in liquidation must comply with the obligation to distribute according to the size of registered shareholdings, rather than any concept of equitable fairness.

Any directors and/or liquidators of failed feeder funds should pay close attention to this landmark judgment in deciding how they should distribute any remaining value to investors.

Footnotes

1 Pearson v Primeo Fund (in Official Liquidation) (unreported) FSD/27/2013 – 2 September 2016

2 See also "Ranking of Redemption Proceeds in Cayman Liquidation" – 18 August 2016

3 Primeo Fund (in Official Liquidation) v Pearson [2015 (1) CILR 482]

4 The Court had already found in a previous judgment that the In Specie Subscription was not void for mistake and was binding and enforceable in accordance with its terms.

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.