First the US housing market unexpectedly threw the asset-backed investment world into a tailspin. Now, seemingly adding insult to injury, a pair of decisions from a prominent New York federal court have raised quite a fuss by ruling that the Cayman liquidators of two Cayman-registered hedge funds would not be recognised in US bankruptcy courts.
This article briefly reviews the two cases and concludes that this is likely an instance of much ado about nothing, as the type of hedge funds involved are designed to have only a tenuous connection to the Cayman Islands and creditors and other interested parties based in the Caymans can certainly expect a warm welcome from US bankruptcy courts if they pursue claims there. The Cayman Islands will maintain its place among the most desirable incorporation venues despite these decisions and Cayman finance and legal professionals can expect a sustained and substantial workload of activity in facilitating insolvency administrations inbound from the US and elsewhere.
Bear Stearns – no recognition if no ‘real’ connection to Cayman
The bottom line holding of the Bankruptcy Court for the Southern District of New York, affirmed on appeal to the District Court2, with respect to the two now-infamous collapsed Bear Stearns hedge funds is both quite simple and entirely expected based on the language of the cross-border insolvency law in effect in the US and most of the rest of the world, today: a foreign insolvency representative, such as the joint liquidators appointed by the Cayman court, can be ‘recognised’ and thus receive a wide range of co-operation and support from US bankruptcy courts only if the debtor-company has some substantial economic presence in the jurisdiction of their appointment, that is, the Cayman Islands3. As with many, perhaps most, other Cayman-based financial companies, the Bear Stearns funds were largely ‘letterbox’ companies with only the most attenuated connection to Cayman. Beyond their initial Cayman registration and some periodic financial auditing conducted from the Islands, the funds had no pre-petition administrative or economic presence in the Cayman Islands at all. The movement of liquid assets into the jurisdiction after the filing of an insolvency petition was both irrelevant for this analysis and potentially subject to challenge and reversal in an insolvency proceeding.
Given that insolvency administration is essentially a matter of protecting, sorting out, and distributing assets and other economic rights, only a jurisdiction with a substantial connection to those assets and rights can expect to be accepted as the proper administrative centre of a cross-border insolvency proceeding involving the debtor-company. The Cayman liquidators sought relief from the US Bankruptcy Court because they needed protection from suits lodged in the US, largely to protect assets located in the US, which the liquidators proposed to transfer to the Caymans for administration. The liquidators expressed concern that the level of ‘comity’ and ready co-operation that they had expected from US courts was not immediately forthcoming. They failed to appreciate that, while US law powerfully facilitates such co-operation with foreign representatives, it does so only for representatives appointed by the jurisdiction of a debtor-company’s principal place of business (‘centre of main interests’), or at least a jurisdiction where the company had a significant operating base (an ‘establishment’). The Bear Stearns case was not a close call; neither of the funds had any substantial pre-petition administrative or economic connection to Cayman.
The Cayman Companies Law might well transfer all management authority from the board to appointed liquidators, and it might well require that those liquidators wind up, or otherwise administer, the company, but if the company had no administrative decision-making or even asset-based connection to the Cayman Islands before insolvency set in, Cayman law practically can assign local liquidators only the administrative powers that were exercised by the previous board in Cayman. If, as with the Bear Stearns funds, all of the day-to-day administration, investment management, and record-keeping is conducted outside Cayman, then Cayman-based insolvency administration cannot bring those powers back to the Islands for the purpose of retrieving and administering assets located in other jurisdictions. In other words, if no one in the Cayman Islands would have made a decision with respect to suits and assets in the US before the insolvency filing, US and most other countries’ cross-border insolvency law does not recognise that kind of power for Cayman-appointed representatives after insolvency. With respect to assets in the Cayman Islands, local practitioners may well have more power and responsibility, but foreign jurisdictions hosting assets and information are unlikely to offer much, if any, assistance to liquidators asserting decision-making authority that only after the insolvency filing emanates from the Cayman Islands.
Basis Yield – a hint at an illusory exception?
The other prominent case, issued by the same court in the same general time frame, seemed to open the door to greater co-operation with Cayman-appointed hedge fund liquidators, though this possibility is likely illusory. When the US bankruptcy court invited the Cayman liquidators of the Basis Yield Alpha Fund to submit documentary evidence of the kind of economic connection to Cayman that might distinguish this case from the Bear Stearns case, the liquidators demurred, relying on the presumption in the law that a debtor-company’s jurisdiction of registry (incorporation) is its ‘centre of main interests’, entitling them to automatic co-operation. On the one hand, this seems to have been a poor strategy, as the court here, as in the Bear Stearns case, proceeded to take judicial notice of a string of facts that likely rebutted the presumption. The court suggested that documentary evidence might volley the presumption back over the net by showing that this particular fund was organised in a way more connected to the Cayman Islands, but without some evidence, the court was unwilling to rely on a manifestly questionable presumption.
On the other hand, however, the liquidators of the Basis Yield fund – and most other Cayman hedge funds – probably could not produce such evidence. Companies like these are most often registered in the Caymans as ‘exempted’ companies, which are prohibited by §193 of the Cayman Companies Law from engaging in business activity in the Caymans “except in furtherance of the business . . . carried on outside the Islands”. Indeed, §184 of the Companies Law amplifies this restriction by requiring a declaration that “the operation of the proposed exempted company will be conducted mainly outside the Islands.” The range of cases in which a company might comply with these restrictions of ‘exempted company’ status, yet manage to maintain its administrative decision-making centre or principal assets in the Caymans, seems vanishingly small, if such cases can exist at all. Theoretically, though, if some pessimistic founders of a Cayman hedge fund plan ahead for a main insolvency case in Cayman with co-operation from the US, the Basis Yield case reminds them that this is possible, if challenging.
Minimal implications of these decisions.
One should take care not to over-react to these decisions. First and foremost, the Cayman Islands are not, as a result of these cases, any less desirable a venue for hedge funds and other financial companies. The kinds of risks encountered by the Bear Stearns and Basis Yield funds were unprecedented and promoters presumably do not plan for failure and insolvency administration; they plan for success, and the Cayman Islands has become deservedly famous for facilitating such successes. Ultimately, the value of the Cayman legal and regulatory structure is not in its administration of insolvency, but in its sophisticated facilitation of business for companies seeking to minimise transaction costs and maximise profits. This has not changed with Bear Stearns and Basis Yield, and this is not likely to change even as insolvency grips more companies like these funds.
The more subtle lesson of these decisions is that Cayman hedge fund managers and insolvency practitioners should likely file insolvency cases first in the US, or wherever the fund’s administrative decision-making or asset centre is, with Cayman proceedings supporting the ‘main’ proceeding, not vice versa. As a result of the reforms described by Le Cornu and Clingerman in last quarter’s issue of this review5, Cayman courts, lawyers, and accountants will continue to play an important role in cross-border insolvency cases involving such entities, as their co-operation will doubtless be crucial to efforts to discover financial dealings and assets in hedge fund and other financial company insolvencies. While the procedural ‘control centre’ of any given insolvency case may well seldom be in the Islands, in light of these decisions and similar cross-border insolvency law in most other countries, if assets or other co-operation from Cayman entities is desired, Cayman law now dovetails with US and other world laws that encourage and facilitate co-operation in cross-border insolvency cases like Bear Stearns and Basis Yield.
Assets in the US may well be administered and divided according to US or other non-Cayman insolvency law, but Cayman-based creditors and investors fear not. The substantive impact of these laws is converging today and Cayman creditors and investors are likely to receive similar treatment in insolvency cases administered in Cayman or most any other prominent jurisdiction. Cayman individuals and entities are fully able to participate and receive distributions as respected parties, for example, in US bankruptcy cases. The substantive implication of the Bear Stearns and Basis Yield decisions is minimal, even though the procedural and strategic implications are important for Cayman insolvency practitioners and advisers. The most salient conclusion is, as one commentator so incisively observed, “the struggle between the secretive nature of hedge funds and the open, public process of bankruptcy in the US continues.”