Shareholder wind-up of hedge funds: An Overlooked issue

The courts in both the Cayman Islands and the British
Virgin Islands have recently handed down a number of judgments focused on the
liquidation of hedge funds and the circumstances in which it is just and
equitable for funds to be wound up on a petition by one or more shareholders.

The courts’ jurisdiction to wind-up companies on the just and equitable basis
is broad based and largely discretionary to allow for requirements of “justice
and equity” (per Crossman J in Re Davis and Collett Ltd [1935] Ch 693 at 701).

In
the context of applications to wind-up hedge funds, recent cases have focused
on the circumstances in which a fund can be said to have “lost its substratum”.
The basic principle, based on established English authorities, is that where it
has become impossible in a practical sense to carry on the business for which a
fund was established, it can be wound up on just and equitable grounds even
though the petition is opposed by a substantial majority of shareholders. In
this context, the key issue for funds is the circumstances in which it can be
said that it has become practically impossible to carry on the business for
which they were promoted.

Mr
Justice Jones of the Cayman Grand Court concentrated on this issue in his
recent decision in Re Heriot African Trade Finance Limited (FSD no 87 of 2010,
4 January 2011, unreported (“Heriot”)). Most importantly he confirmed
his definition of the test for “loss of substratum” for open ended
investment funds in the following terms (judgment paragraph 30, originally set
out by the same judge in Re Belmont Asset Based Lending Ltd (21 January 2010,
unreported)):

“…it
can be said that it is just and equitable to make a winding up order in respect
of an open ended corporate mutual fund if the circumstances are such that it
has become impractical, if not actually impossible, to carry on its investment
business in accordance with the reasonable expectations of its participating
shareholders, based upon representations contained in its offering document.”

Based
on this test, the judge focused on Heriot’s constitutional documents and
whether they gave active consideration as to how the fund was to be liquidated.
Like most hedge funds, Heriot did not set out how it was to be liquidated in
its constitutional documentation. As a result, the Court concluded that the
liquidation of the fund by its management was not something which the
shareholders should have anticipated in the ordinary course of Heriot’s
business.

Therefore it was held to be just and equitable to make a winding-up
order on the basis that the fund was no longer viable, in the sense that it was
practically impossible to carry on its business in accordance with the reasonable
expectations of its participating shareholders based upon the representations
contained in the constitutional documentation. This decision was arrived at
despite the majority of investors opposing the petition and giving evidence of
their support for the fund’s existing manager liquidating the fund’s assets. 

Based
on this judgment and earlier decisions along similar lines, where a fund’s
constitutional documentation does not deal with how the fund is to be
liquidated, there is a serious risk that the court will decide that the winding
down of the fund by its own management was not something which the
participating shareholders should have anticipated in the ordinary course of
its business. Consequently in these circumstances, an unhappy shareholder may
be able to successfully petition the court for a winding-up order on the basis
that the fund has “lost its substratum”.

Mr
Justice Bannister in the BVI has approached the same question in a different
way. In recent decisions (for example Aris Multi-Strategy Lending Fund Ltd -v-
Quantek Opportunity Ltd, 15 December 2010, unreported) he has set out his view
that the underlying principle in applications for just and equitable winding-up
based on “loss of sub-stratum” is that minority shareholders seeking a
winding-up on the grounds that the business life of a fund has come to an end
will only be permitted to overcome the will of the majority shareholders if
they can show that further conduct of the fund’s business is impossible (as
opposed to impractical). In his judgment, simply because a fund seeks to wind
down its affairs does not mean that it has ceased to carry on business or that
it is impossible for it to carry on business and hence it cannot be said to
have lost its substratum, even if the liquidation of the fund is not expressly
dealt with in its constitutional documents.  

The
decisions of Mr Justice Bannister and Mr Justice Jones are both first instance
judgments. Since both the Cayman Islands and BVI base their law on English
principles, both should theoretically approach the issues arising in the same
way. Unfortunately, these divergent decisions have created a position where
there is real uncertainty about an investor’s ability to wind-up a fund seeking
to liquidate its assets.

It would clearly be helpful if matters could be
clarified on appeal. Unfortunately, no appeal appears likely in the short term
because there are real practical difficulties for funds in appealing a
winding-up order. If a stay of the winding-up order is not obtained, it is likely
to be very difficult to unwind the position once the liquidator has been in
office for some months.

Further, the Court will only grant a stay where a
refusal to stay would operate so as to render a successful appeal nugatory (ie
worthless). In practice, proving this to the court’s satisfaction is very
difficult as both England and the Cayman Islands have case law to the effect
that stays of winding-up orders are hardly ever granted (see, for example, Re A
& BC Chewing Gum Ltd [1975] 1WLR 579). Even if a winding-up order is
stayed, it is likely that the court will order that the fund provide security
for the legal costs of the petitioning investor and it is likely to have to
persuade other investors to provide this security.  

To
deal with the issues raised by Heriot and similar recent decisions, new funds
are now including express provisions allowing for the winding down of their
affairs by management. Although existing funds are unlikely to have such
provisions in their constitutional documents, they are being advised to review
and consider amending their constitutional documents to similarly allow
existing management to conduct a wind-down of the fund’s affairs.

Some funds
are going further and specifically excluding the possibility of investors bringing
petitions, as permitted by section 95(2) of the Companies Law (2010 Revision).
The irony is that the pro-investor approach adopted by Mr Justice Jones is
likely to mean that in future investors are deprived of the just and equitable
winding-up remedy all together.  

 

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Tim Richards
Tim has handled a wide variety of major cross border litigation and arbitration and has represented a wide variety of blue chip clients including major international banks, asset managers, hedge funds, public sector corporations, the UK national lottery and European steel manufacturers. After graduating from Oxford University, Tim trained and qualified as a solicitor with CMS Cameron McKenna LLP in 1999, where in recent years he was seconded to the CMS insurance litigation and energy litigation teams to run major disputes.

Tim Richards
Senior Associate
Mourant Ozannes
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42 North Church Street
PO Box 1348
Grand Cayman KY1-1108
Cayman Islands


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