In a recent judgment of the Grand Court in the matter of FIA Leveraged Fund (unreported, Grand Court, 18 April 2012), the Court has laid down some general principles applicable to the in kind or in specie distribution of fund assets to redeemed investors and the proper exercise by directors of the power and discretion to make payments in kind.
The economic turmoil experienced by the funds industry since 2008 means this subject is of particular relevance to those funds and managers facing high redemptions and illiquid assets. The wide use by Cayman Islands funds of synthetic side pockets and SPVs to facilitate in kind redemption of SPV shares to redemption creditors was until now completely untested.
Notably the decision in FIA Leveraged Fund did not call into question this now common practice. Instead, the Court focused on the particular assets that had been transferred and whether they were sufficient to discharge the redemption debt. This decision must provide some comfort that the use of synthetic side pockets as a means of dealing with redemptions does not, in and of itself, offend. However, whether it is acceptable in any given case will obviously be dictated by the terms of the constituent documents of the fund and the nature and value of its underlying assets.
FIA Leveraged Fund (the “Fund”) was a feeder fund in a multi-tiered master-feeder structure. The ultimate Master Fund, a Bermuda entity (the “Master Fund”), held the structure’s investments. The petitioners, three US pension funds that collectively had over US$130 million invested in the Fund, sought to redeem their investments effective between March and August 2011. It was not in dispute that the redemption requests were properly made and that by 31 August 2011, at the latest, the petitioners had effectively redeemed.
The Fund’s offering document provided for payment of redemptions in cash “or in assets of the Fund other than cash”. The Fund’s and the Master Fund’s constituent documents also provided that the value of assets so paid would “be determined by the board of directors in consultation with the investment manager in its sole discretion …” and that “any valuation made … shall be binding on all persons”.
The Fund first sought to satisfy the redemption requests by assigning to the petitioners promissory notes, due and payable in June 2012, that had been issued to it by the Master Fund. The petitioners rejected these distributions and, following filing of the petition, in February 2012, the Fund and Master Fund took steps to (i) incorporate a Delaware company (the “SPV”); (ii) transfer to the SPV a small amount of cash and an option (the “Option”) to invest $65 million in preferred shares of United Community Banks Inc. (“UCB”), in return for SPV shares; and (iii) make an in specie distribution of the SPV shares to the petitioners. The Fund claimed that this discharged all of its immediate debts to the redeeming investors.
The petitioners sought to wind up the Fund on the basis of insolvency but also on just and equitable grounds. They claimed that the SPV shares were worthless and did not discharge the redemption debt.
In response, the Fund claimed that there was a genuine dispute about whether or not the petitioners had been given an in specie distribution that realistically represented the value of their investment, and that the dispute should be the subject of writ action rather than a winding up petition1.
Accordingly, the primary issue before the Court devolved into whether the SPV shares represented a valid in specie distribution.
The Court held that there could be no genuine dispute that the Fund owed a substantial debt to the petitioners that had not been satisfied by the in kind distribution. The Fund asserted that the value of the Option was around $136 million, this being supported by an independent valuation. However, in order for the SPV to exercise the option, it would have to pay $65 million to UBC by May 2012 and had no means to do so (or the petitioners would be required to make this further investment).
In addition, the share purchase agreement underlying the Option was the subject of a dispute with UBC, in regard to the exercise price, following a recent reverse stock-split. The court considered the true value of the Option and held that it was commercially worthless (or, at best, worth much less than the liabilities owed to the petitioners). There were too many variables, including payment of the $65 million (which the SPV did not have) and the litigation surrounding the stock-split.
The court found that the Fund was insolvent and that it should be wound up. The court also held that the Fund could no longer achieve its purposes and should be wound up on just and equitable grounds2.
The court emphasised the duty of care and the requirement on directors to act in good faith when making an in specie distribution. Despite the provisions in the Fund’s and the Master Fund’s documents granting the directors full discretion to determine the value of the assets to be distributed, the court held that it would not be reasonable to conclude that the Fund’s documents vested in its directors an exclusive and absolute discretion to effect an in specie distribution, which would not give commercial efficacy to the obligations owed by the Fund to its investors. The Fund could only transfer assets which realistically provided value sufficient to discharge the redemption debt.
An interesting argument
An interesting submission made by the petitioners in this case, but not ruled on by the court, was that the in specie redemption payments made by the Fund were not in accordance with the terms of its offering document. This was on the basis that the offering document required in kind distributions to be made from the “assets of the fund”, which must be taken to mean assets held on the relevant redemption date. In this case the final redemption date was in August 2011, while the SPV was not incorporated until early in 2012. It is conceivable that this argument may be further developed and considered in later cases.
However, the likely success of any such argument will largely depend on the exact terms and the attendant interpretation of the relevant fund documents.
This decision makes it clear that an objective and good faith approach must be adopted in settling on the assets to be transferred to an SPV. “Cherry picking” will not be condoned. This confirms the view (and approach) long held by practitioners in the Cayman Islands, and operates as a timely reminder to funds and operators to consider carefully, objectively and fairly, what assets will be transferred in support of an in specie redemption.