Fallout from the sub-prime credit crisis, the Bernard Madoff affair and recent events in the banking and finance sector have had a severe impact on the hedge fund industry leaving many offshore funds facing substantial redemption requests with insufficient liquidity to meet them. Funds have resorted to using a number of mechanisms to deal with accelerated redemptions and illiquid assets.
Such mechanisms typically include side-pockets, gates, lock-ins, in specie redemptions, liquidations and the suspension of redemptions. It is not surprising, then, that disputes regarding the exercise of such powers, suspensions, in particular, have recently come before the courts in offshore jurisdictions, as fund operators find themselves in conflict with investors attempting to jump ship. The three decisions discussed herein provide funds and investors with guidance concerning the proper exercise of suspensions and the remedies that may be available when disputes arise. In particular, there is consensus that a redeeming investor becomes a creditor on the redemption date. There remains an open question as to whether a decision to suspend redemption payments may be successfully attacked on the grounds that it is oppressive to a minority.
Cayman Islands: In the Matter of Strategic Turnaround Master Partnership Limited (12 December, 2008)
This case involved a redemption request received by a Cayman Islands fund for the redemption date of 31 March, 2008. The offering document provided that payment of the redemption price would be made within 30 days. However, on 17 April, 2008, the directors resolved to suspend redemptions and refused to pay the investor’s redemption proceeds.
The investor petitioned to wind up the fund on grounds that it was unable to pay its debts and on a just and equitable basis. At first instance, the Grand Court of the Cayman Islands refused the fund’s application to strike out the petition and the fund appealed.
A matter of construction:
The Court of Appeal emphasised that the conclusions reached were based, purely as a matter of construction, on the terms of the constituent documents of the fund. Accordingly, the decision turned on the particular facts and should be considered in that context.
The court held that the redeeming investor became a creditor of the fund on the redemption date, even though the amount owed had not then been determined. In particular, the court noted that the articles of association of the fund provided that the price of the redeemed shares would be a liability of the fund from the redemption date. The decision confirmed a commonly accepted view among many legal practitioners in the Cayman Islands – generally, a redeeming investor becomes a creditor if the relevant redemption date passes before any suspension is declared.
Relying on principles drawn from English authorities, the court confirmed that a redeeming shareholder remains a member of the company until he has received payment and his name has been removed from the register of members.
The court focused on Article 40 of the articles, construed to provide that the process of redemption is not over until the member’s name is removed from the register and the shares available for re-issue. Accordingly, the court held that the investor continued to be a member of the fund, bound by the majority of the articles and the offering document, after the redemption date. This led to the curious result that for the period between the redemption date and payment of the proceeds and/or removal of its name from the register, the redeeming investor was a member and a creditor of the fund with respect to the same pool of money. It is unclear what rights a member retains in such circumstances and whether, for example, a redeeming investor would still have the right to requisition or vote at meetings.
Valid suspension and a definition of redemption:
The court held that the specific power to suspend redemption payments in the offering document, combined with the power to suspend redemptions in the articles, empowered the fund to validly suspend redemptions and, more importantly, to suspend the payment of redemption proceeds prior to the scheduled payment date.
As part of this analysis, and coupled with its earlier comments on Article 40, the court found that “redemption in these articles must be referring to the entire process of redemption including (a) the notice to redeem (b) the debt that arises on the redemption date (c) valuation of the NAV at the redemption date and, as a consequence, the redemption sum (d) the payment of the redemption sum, and (e) the removal of the member from the register.” Leaving to one side the issue of whether the court’s reading of Article 40 was correct – that article commencing with “once a share is redeemed, the Member shall cease to be entitled to any rights in respect of it” – and the issue of whether removal of a member’s name from the register would be better considered a formality consequent upon redemption, rather than the legal event that causes a member to lose its rights as such, it is submitted that the best interpretation of the court’s decision concerning the meaning of redemption is that it was derived from the fund’s articles and offering document. It is unlikely to be applied generally as a matter of law. The extent of the powers of suspension and the meaning of redemption are best determined in each case by careful reference to the particular articles and offering documentation.
Status to petition:
As a result of the above findings, the court held that if the redemption had been validly suspended, the petitioner did not have standing to petition on the grounds that the fund was unable to pay its debts as the debt was a future debt, not presently due and payable due to the suspension. It should be noted that there is no balance sheet test of insolvency in the Cayman Islands although there is such a test in Bermuda and the British Virgin Islands. However, the investor did have standing to petition on a just and equitable basis and the court refused to strike out that part of the petition and permitted it to be amended. It, therefore, remains to be seen whether the decision to suspend payments will be held to have been ultra vires and the conduct of the fund oppressive.
Impact of the decision:
While the decision in Strategic Turnaround turned on the particular provisions of the constituent documents of the fund, it will certainly have a more general impact, particularly with respect to the drafting of constitutional documents of Cayman Islands’ investment funds. In particular, fund documents are likely to provide specifically for suspension of redemption payments and may include tighter terms concerning when redemption is effective and an investor loses its rights as a member in the fund. Further, there will likely be an increase in investor scrutinisation of the terms of fund documents, as decisions of the Cayman courts highlight the necessity for clear enunciation of redemption rights and suspension powers.
The legal status of a redeeming investor has also been considered in recent decisions in Bermuda and the British Virgin Islands, as briefly discussed below.
Bermuda: In the Matter of Stewardship Credit Arbitrage Fund Ltd.
This case involved a petition before the Supreme Court of Bermuda’s Commercial Court to wind up an investment fund on the grounds that it was insolvent and on just and equitable grounds and an application by the fund to strike out the petition.
One of the main issues considered by the court was whether the redeeming shareholders had status as creditors sufficient to enable them to present a winding up petition. The court held that, as redeemed shareholders who had not yet been paid their redemption price, they were creditors with the requisite standing.
British Virgin Islands: SV Special Situations Fund Limited v Headstart Class F Holdings Ltd.
In this decision, the British Virgin Islands High Court of Justice considered an application by a fund to set aside a statutory demand served by a redeeming investor. Although the case turned on the factual question of whether a side agreement had been reached to make redemption payments, the court did go on to consider the question of whether the investor was a creditor with standing to serve a statutory demand and present a petition to wind up the fund under the British Virgin Island’s Insolvency Act 2003. The Court concluded that the redeeming investor was a creditor with the necessary standing to serve a statutory demand and to present the petition.
Recent decisions in Bermuda, the British Virgin Islands and the Cayman Islands have confirmed a number of important aspects of the law regarding redemptions and the suspension thereof by offshore funds. Given the turmoil in the hedge fund industry, these decisions will be of importance to the operators of funds and their advisers as well as investors faced with redeeming their investments from offshore funds in distress.