No solvency test for payment of redemptions from Cayman Funds?

2014 was a year of significant judgments in the area of claw-back claims. Further clarification has been received recently as to whether, and in what circumstances, liquidators can recover from fund shareholders redemption proceeds paid prior to revelations of massive frauds (usually Ponzi Schemes uncovered in the wake of the 2008 financial crisis). The question whether such claims will succeed is now, in light of the decisions over the last 12 months, more likely to be answered in the negative, which will provide considerable comfort to those concerned about exposure to claw-back action.

In RMF Market Neutral Strategies (Master) Limited (RMF) v DD Growth Premium 2X Fund (in Official Liquidation) (DD) [1]  of the Cayman Islands Grand Court, the Chief Justice considered claims by Cayman liquidators to claw-back redemption proceeds paid to investors, on the basis that the payments were:

• (i) paid out of DD’s capital (contrary to the maintenance of capital doctrine which exists to prevent the unauthorised depletion of a company’s assets) at a time when DD was insolvent; and
• (ii) paid in preference to other creditors and thus voidable and recoverable pursuant to a liquidator’s statutory powers.

RMF was one of seven investors who had submitted valid requests for the redemption of their shares from DD for a redemption date of 31 December 2008. It was not in issue that the redemption requests were all valid and had been accepted by DD.

Although DD was found by the Court to be insolvent on both a cash flow and balance sheet basis at the time that the redemption payments to RMF were made, and although only some of the redeemers received payment, the liquidators’ claims for a claw-back of the payments to RMF were unsuccessful.

Under the Cayman Islands Companies Law (the Companies Law), share premium (i.e. the amount by which the issue price of a company’s share exceeds its nominal or par value) does not form part of the capital of the fund (unlike in England & Wales). Under section 37(6)(a) of the Companies Law it is  unlawful to pay redemptions out of capital if, immediately following the payment, the fund is insolvent (i.e. unable to pay its debts as they fall due in the ordinary course of business).  The Court undertook an extensive review of the capital maintenance doctrine as set out in the Companies Law and  confirmed that share premium is not ‘capital’ for the purposes of section 37(6)(a) and therefore the redemption payments made to RMF from share premium (as is extremely common for Cayman investment funds) were not unlawful [2].

It was also held that payment of the redemption proceeds to some redeemers but not others did not constitute an unlawful preference. Whilst RMF was clearly paid ahead of the three unpaid redeemers, the liquidators had not established that it was the “dominant intention” of DD’s management to prefer RMF over other investors.  Interestingly, the Court found that the reason why RMF was paid instead of the unpaid redeemers was in fact due to the “unrelenting and escalating pressure” applied by the principals of RMF, on DD’s principal, and his desire to buy more time to somehow recover from the Fund’s hopelessly insolvent position.

In the judgment, the Court referred to and drew support from the recent decision of the Privy Council in Fairfield Sentry[3], in which the liquidators of a BVI investment fund were not entitled to claw back redemption payments made before the Madoff Ponzi scheme fraud came to light, by reason of the fact that the fund was bound by the published and certified NAV on which redeeming investors relied. However, it is not clear that the decision in Fairfield Sentry actually provides such support -  the Privy Council’s remarks in Fairfield Sentry related to the position of unredeemed investors vis a vis redeemed investors, not the position of redeemed investors inter se as in RMF.

There are a number of surprising aspects to the RMF decision:

1. The Court held that redemption payments can be made by a fund which is cash flow insolvent at the time of redemption. The Chief Justice considered the effect of section 34(2) of the Companies Law and highlighted that it is only payment of a “distribution or dividend” (as distinct from a redemption payment), which is subject to a solvency test.  The lack of an applicable solvency hurdle to a redemption payment arguably puts third party creditors at risk. The maintenance of capital doctrine is of course intended to protect creditors; and redeeming investors are, in a winding up context, subordinated to external creditors. Therefore the lack of a solvency test for redemption payments is unlikely to have been the intention of legislators. In RMF there were no external creditors, and the Chief Justice does not address what the position would have been if external creditors had been prejudiced by the payment to this one persistent investor, and so this decision should be seen as being confined to its facts. It remains to be seen whether the Courts would find such payments unlawful where external creditors remain unpaid. The decision seems to be inconsistent with s.37(7)(a)(ii) of the Companies Law which provides that redeemed shareholders may not enforce their right to payment against the company in a winding up if, during the period the redemption was to have taken place, the company could not lawfully have made a distribution equal in value to the redemption price. The RMF decision suggests that payment could be made to redeemed shareholders, who could not enforce their debt in a winding up.
2. The decision appears to confuse the question of why there was a preference, with the question of whether there was a preference. The relevant test as to whether a payment is a preference under section 145 is whether it was made with a dominant intention to prefer a particular creditor[4]. If there is a dominant intention to prefer a creditor, it is arguably irrelevant why that intention was formed. The Chief Justice held the payment was made because DD succumbed to the “commercial pressure” of an extremely persistent investor and the desire to avoid threatened regulatory intervention.. This was not considered to fall within the “dominant intention to prefer” test.  This finding makes it clear that there is a very high evidential threshold in order  successfully to show there has been an unlawful preference, and is perhaps the reason why many other common law jurisdictions (for example, Scotland, Australia, BVI and the United States) have moved to an effect based test (with an exception for payments made in the ordinary course of business)[5]. 
3. DD was clearly hopelessly insolvent at the time that the December redemption payments were paid; yet the decision contains little censure of the conduct of DD’s management in allowing the fund to continue to accept subscriptions and make redemptions in those circumstances. In such circumstances, of course, an insolvent company ought to take steps to put the company into the hands of a liquidator to ensure that the interests of creditors take priority over members[6]. 
4. At one point in the judgment, the Chief Justice states: “the constitutional documents of these companies then (as now), allowed for redemption on the ‘first come first served’ basis, depending on when redemption requests were notified”. This should not be construed as suggesting that the date of submitting a request for redemption could have some significance to the priority of payment. It is generally accepted that provided notice is given within the notice period stipulated in the fund documents, no significance is to be ascribed to when within that period the redemption requests are submitted, in the absence of an express provision to that effect (e.g. a gating provision).

One obvious implication of the decision in RMF is that a “he who shouts loudest…[gets paid]” principle may now apply, and that there is nothing to stop an insolvent fund satisfying some redemption requests over others.   If there is no need to pro-rate payments to redeemers of illiquid funds then investors may well be incentivised to exert pressure to get to the front of the line. Some funds’ gating provisions (not in the case of DD) ensure that requests will be pro-rated; but where such provisions are not in place it is possible for funds to take a pragmatic approach to the payment of their redeeming investors, and the only remedy available to a small investor to ensure a pro-rata distribution is made, would now appear to be a petition to have liquidators appointed.

The decision in RMF is not the final word on claw-back claims in the Cayman Islands. Other similar claims brought by liquidators are ongoing. Undeterred, the DD liquidators have appealed the judgment (although it is unclear on what grounds) and commenced a number of fresh claw-back actions on 10 December 2014.

The case of Palm Beach Offshore Ltd (In Official Liquidation) (25 November 2014), involved a fund exposed to the Petters’ Ponzi Scheme. The case is of interest because it suggests that the finding in RMF is considered by some to be relevant to the position of redeemed investors in the context of a winding up. In Palm Beach liquidators had rejected a proof of debt by a redeemed investor on the basis that it was unenforceable under section 37(7)(a)(ii) of the Companies Law because the company could not, at any time during the period between the date of the redemption and the date on which the liquidation commenced, have lawfully made a distribution equal in value to the redemption price because it was insolvent at that time. This argument relied on the effect of section 34(2) and / or section 37(6), the effect of which is that a distribution to shareholders is unlawful  if, immediately following the payment, the company would be unable to pay its debts as they fall due. However that argument was abandoned as a consequence of the decision in RMF released two days before the hearing took place. The reason given was that the plaintiff’s understanding of the RMF decision was that “a redemption payment out of share premium or capital would be lawful, irrespective of the company’s solvency at the time of the payment, provided only that the payment was authorised by the articles.”

It is surprising that an argument based on section 37(7)(a)(ii) of the Companies Law was abandoned because the RMF judgment does not specifically consider that subsection, and section 37(7) is not impacted by the decision in RMF. As stated above, section 37(7)(a)(ii) relates to the circumstances in which a redeemed investor may enforce its right to payment against the company in a winding up, and provides that the right may not be enforced if during the period the redemption was to have taken place the company could not lawfully have made a distribution equal in value to the redemption price. This use of the term “distribution” takes 37(7)(a)(ii) outside the remit of the decision in DD, which drew a clear distinction between distributions and redemptions. It appears to remain open to a liquidator to argue that if the fund would be unable to pay its debts as they fall due when the redemption payment was due, the effect of 34(2) and 37(7) is that the redeemed investor could not enforce its right against the company in a winding up.

It is of interest that the Court in Palm Beach is also due to consider arguments concerning the statutory power to rectify the register where shareholders have been redeemed on the basis of an overstated NAV. Clawback claims have also been issued by the liquidators of the Weavering Macro Fixed Income Fund Limited; and so it is clear there are several more battles to be fought in Cayman in this particular arena in 2015.

[1] 17 November 2014

[2] Surprisingly reference was not made during the analysis to the English Court of Appeal’s decision in HMRC v First Nationwide [2012] EWCA Civ 278 which found as a matter of fact that share premium was not capital for the purposes of the capital maintenance rules.

[3]Fairfield Sentry Limited (in liquidation) v Migani & ors [2014] UKPC 9

[4]See Segoes Services Limited (in Liquidation) v Oeoka, Kaweski and Highland Consulting Limited [2006] CILR Note 1; and In re M Kushler [1943] 1 Ch. 248

[5]England has also watered down the dominant intention to prefer test by enactment of section 229(5) of the Insolvency Act 1986, where in order for a transaction to amount to being an unlawful preference, the decision to pay a particular creditor must have been made “with a view to giving such creditor…a preference over the other creditors” and being “influenced by a desire to put (such creditor) in a better position than he would have been in in the event of insolvent liquidation”;

[6]The rights of creditors become paramount to those of members when a company becomes insolvent West Mercia Safetywear v Dodd [1988] BCLC 250

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