Matthew Goucke and Chris Keefe
A recent judgment of the Judicial Committee of the Privy Council1 (Privy Council), the ultimate appellate court of the Cayman Islands, has provided certainty for investors and insolvency practitioners with respect to the enforceability and priority of investors’ claims for unpaid redemption proceeds in the winding up of Cayman Islands investment funds.
The Privy Council decision is the most recent in the ongoing liquidation proceedings of Herald Fund SPC (Herald), a segregated portfolio company incorporated in the Cayman Islands which was one of the largest so-called feeder funds into the Madoff Ponzi scheme.
The case involved an important point of statutory construction, namely how section 37(7) of the Companies Law operates in the context of significant unpaid redemption proceeds sought to be enforced several years after the discovery of the Ponzi scheme notwithstanding that, with the benefit of hindsight, those redemption claims, valued at almost $200 million, were clearly based on a wholly fictitious net asset value.
The issue is one that has rarely confronted the Grand Court of the Cayman Islands and this was the first time it had been considered at the highest appellate level.
Affirming the rulings of the Grand Court and the Cayman Islands Court of Appeal, the Privy Council found that, as a matter of construction, section 37(7)(a) of the Companies Law does not apply to the claims of certain classes of Herald’s unpaid redeemers in circumstances where, at the commencement of the winding up, the relevant redeemable shares had been “redeemed” in accordance with the terms of Herald’s memorandum and articles of association. In other words, the redemption date had occurred prior to any suspension being implemented, notwithstanding that payment had not been made and was not due to be paid at that time.
The Privy Council found that “redemption” occurs on surrender of the status of shareholder, which is entirely a function of the terms of the contract of membership between a company and its members among themselves – expressing the freedom that shareholders and a company have to shape their relationship as regards redemption or purchase of a company’s shares.
The Privy Council did not accept the appellant’s argument that “redemption” ought to have an autonomous statutory meaning (being the completion of the entire process of redemption, including payment). As a result, the enforceability of a claim for unpaid redemption proceeds is now entirely dependent on how “redemption” is defined under the relevant articles of association of a particular company.
Regrettably, the Privy Council did not address in its judgment a number of the arguments advanced by the appellant in support of a consistent statutory definition at the hearing of the appeal.
The appellant was, however, successful in opposing the claims of intervening investors who had submitted redemption requests after Herald’s board had implemented a suspension of redemptions in December 2008 and who asserted that they had enforceable claims arising under section 37(7) of the Companies Law. The Privy Council rightly rejected these claims on the basis that the suspension meant that the terms of redemption provided for it to take place at a date later than the commencement of the winding up (in circumstances where Herald’s directors never lifted the suspension prior to that date). In terms of the application of section 37(7), the Privy Council in its judgment did not refer to the various academic texts cited by the appellant which suggested that redemption for the purposes of the section meant the completion of the entire process of redemption, including payment. It instead found that section 37(7) envisages situations where shares are, or are liable to be, redeemed or purchased, but where a company had for any reason wrongly failed to take steps necessary to enable the redemption or purchase at the applicable date in accordance with the terms of the relevant articles of association.
Acknowledging the very limited practical application of the section, which must arise given the construction favored by the Privy Council, the board noted that “the likelihood in practice of successful section 37(7) claimants may well be slight.”
Essentially, in the context of the articles of most contemporary Cayman Islands investment funds, this decision means that redeeming shareholders have valid claims for the payment of redemption proceeds as at the relevant redemption day, which claims are enforceable in a winding up regardless of (i) whether those claims are based on a net asset value which has been wholly misstated as the result of a pervasive fraud (as was the case with respect to Herald); and (ii) a company’s ability to make payment out of either share capital or share premium at any time prior to the commencement of a winding up.
The Privy Council also appears to have gone a step further than it did in Fairfield Sentry v Migani where, in the context of an action by the liquidators of Fairfield Sentry seeking to recover redemption proceeds which had already been paid to investors based on a wholly fictitious NAV, the Privy Council found those proceeds could not be clawed back in circumstances where payment had already been made prior to the commencement of the winding up. In this case, the Privy Council sought to draw “a precise line” (or rather extend the line) so as to allow investors to escape loss (and perhaps with significant fictitious profit) in a liquidation where they have ceased to be a shareholder under the terms of the relevant articles of association prior to the commencement of the winding up, notwithstanding that no payment has in fact been made (nor could it have been made as a matter of fact at the relevant time).
It is an unfortunate consequence that unredeemed investors will ultimately bear the loss in a liquidation once claims which are based on a misstated NAV have been paid, simply because certain investors submitted redemption requests a matter of days before others and in circumstances where the resultant suspension was due to no fault of the company or its directors, but solely based on the exposure of the Madoff fraud.
This decision means that, in times of uncertainty, boards of investment funds will need to act quickly in deploying suspension or gating mechanisms to ensure that, to the extent possible, any unforeseen loss is borne by the investor base as a whole.
Importantly, however, the Privy Council reaffirmed the Cayman Islands Court of Appeal’s finding that the claims of unpaid redeemers rank behind the claims of ordinary third-party creditors; although it left open the seemingly difficult question as to the priority to be afforded between claims for unpaid redemption proceeds that sit outside section 37(7) and those claims arising under the section.
While the Privy Council’s decision provides finality as to the appropriate treatment of claims for the payment of redemption proceeds in a winding up, it is likely that new and existing funds alike (together with their respective investors and prospective investors) may reconsider new formulations of what “redemption” means under their individual constituent documents in order to navigate the unfortunate loss-allocation consequences which may arise pursuant to this judgment. The door of course remains open for legislative reform in light of the very limited practical application of section 37(7) of the Companies Law.
Matthew Goucke and Chris Keefe act for Mr. Pearson, the additional liquidator of Herald.
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