Custodian role in the limelight

As a result of the bankruptcies of
feeders funds and investment vehicles underlying Bernard L Madoff Investment
Securities LLC and other recent Ponzi schemes, the authority and culpability of
feeder fund shareholders vis-a-vis their own customers in certain situations is
being put into the limelight by these shareholders who may try, or are trying,
to limit their liabilities to feeder funds and as well as to their own

The issues arise from a number of
factors, not least: 

  1. most articles and
    memoranda of association for funds structure the capitalisation of the entity
    on the basis of shareholdings  
  2. the laws for most
    commonwealth jurisdictions provide for clear legal distinctions between
    “creditors” and “shareholders” and the rights and remedies of those classes in
    relation to a corporation are distinctly different  
  3. the role of a
    purported custodian can be to act as the trustee or agent for its customers in
    relation to their investment transactions 
  4. purported
    custodians sometimes sign the subscription agreements and request redemptions on behalf of their customers and the extent of disclosure often is related more
    to the convenience of the custodian and depends on the arrangements it has with
    its customers rather than on the legal implications of the same in relation to
    the fund 
  5. transfers
    in connection with transactions sometimes are received first by the custodian
    and then subsequently transferred to its customer, and such customer may withdraw the funds transferred externally from the custodian. 

The above factors are relevant in three
main scenarios: first, when a customer of a purported custodian wants to
petition to wind up a fund; second, when a customer wants to lodge a proof of
debt in the liquidation of an estate and otherwise participate in the estate
(eg attend creditors or investors meetings), and third, when an insolvency
practitioner takes steps to claw back redemptions or fictitious profits for the
benefit of the estate.

Where a shareholder in a fund believes it has sufficient grounds to petition
for the winding up of a fund, the question of whether the shareholder has
authority to bring such an application is relatively uncontroversial. The
shareholder, given its appearance on the register of members or shareholders
(subject to certain provisos), has the authority under the law to make such an

However, complications may arise for an investor who is a customer
of a claimed custodian (or trust). In a recent case in the Grand Court of the
Cayman Islands, Hannoun v. R Limited and Banque Syz Company Limited [2009 CILR
124], the Court dismissed a petition to wind up a fund as the petitioner did
not have locus standing to petition. In this instance, a customer of the
claimed custodian brought a derivative action to wind up the company in place
of its purported custodian who was unwilling to do so for reasons of conflict.
The court found that it could not expand the law to allow a beneficiary of a
trust, as their interest was unknown to the directors of the company, to seek
the winding up of the company. The court found that only investors entered into
the register of shareholders had proper standing to present a winding up petition.

Issues may arise for purported
custodians and their customers upon a fund being placed into liquidation and
there is a call for stakeholders to lodge claims in the estate. Liquidators are
required to act in accordance with the relevant laws of the jurisdiction in
which they are appointed. In most Commonwealth countries, those laws require
that the Liquidators recognise only the registered shareholders as the
appropriate entity to have standing and make claims relating to members.

purported custodians are not willing to make claims, either for legal reasons,
administrative costs or otherwise, a customer may be unable to have standing or
make a claim in its own name in the estate. This may be resolved by having the
purported custodian transfer its shareholding to the underlying customer, but
this could be made complicated if the relevant laws where is the estate is
being wound up requires that the customer seek court approval of the
post-appointment transfer. Our experience in such applications is mixed. If
such approval is not granted, it may be that the customer will have an economic
interest in the transfer but will not otherwise be able to participate in the
estate (eg voting at shareholders meetings).

The Liquidator may seek to pursue the
clawback of redemptions or other payments made to shareholders prior to the
date of liquidation. The grounds for such recoveries will be specific to each
case, but the liquidator may have claims arising pursuant to the statutory
preference or avoidance provisions in the countries that govern them. In
relation to the latter types of claims, commonwealth jurisdictions often deem
shareholders to be of a specific class in relation to which the applicable time
period for payments which may be clawed back by the liquidator is extended.
Accordingly, the structure of a fund and its subsequent liquidation of a fund
may pose some surprises for an unwary purported custodian and its

There is an increasing number of cases
worldwide, catalysed by the collapse of Madoff and other Ponzi schemes, which
will provide guidance that is likely to impact the way in which purported
custodians act and the arrangements they enter with their customers in future

Cayhedgefundlogo.jpg is the only online community website dedicated to
the hedge funds sector in the world’s largest domicile for hedge funds,
the Cayman Islands.

With regular exclusive content and daily
news updates, it provides investors and industry professionals with
access to the most comprehensive and up-to-date information on the
industry. also hosts a comprehensive database of
industry professionals and provides in depth analysis of current
developments in local other jurisdictions that might affect the local
hedge fund industry and compiles articles about the industry from other
news sources in the limelight.