6 May 2008
Recent hedge fund collapses have focused attention on the ability of courts to protect parties' rights and remedy their losses. With more than 75 per cent of the world's hedge funds domiciled in the Cayman Islands and an increasing number of them in distress, it pays to understand the options that Cayman law offers to interested parties when values start to sink. Successful liquidation strategies can be developed from an informed choice between various options.
RestructuringTypically, the management of a distressed fund will want the opportunity to trade out of its difficulties. It will seek to avoid a run on the fund, in which forced realisations further depress its value. But the fund's constitutional documents may not give directors enough latitude to limit redemptions or lock in investors and restructuring may be required.
Although redeemed but unpaid investors cannot be bound by any restructuring with the remaining shareholders, a court-approved scheme of arrangement may provide the solution. In order to be approved a scheme must have been supported by a majority in number representing at least 75 per cent by value of the groups affected (whether shareholders, creditors or particular classes thereof) at a meeting convened for this purpose. The court must still be satisfied that the scheme of arrangement is fair and it may not approve a scheme if it considers the result to be unfairly prejudicial to an opposing minority.
Voluntary liquidationVoluntary liquidation is a quick and cheap out-of-court procedure to wind up a fund and distribute its assets. It requires a special resolution of the fund's shareholders, which is easily achievable if management holds or controls the only voting shares. Any person can be the voluntary liquidator, although liquidating a hedge fund where the collapse is controversial usually requires the appointment of an independent professional insolvency practitioner: a liquidator's primary duty is to maximise asset recoveries for the benefit of creditors, which will often require investigating claims against management and related parties that may have been responsible for the insolvency.
Voluntary liquidation may not be appropriate if the liquidator has to collect assets or obtain assistance from courts in other jurisdictions, as their appointment and powers will not be readily recognised elsewhere. It may also be inappropriate if the fund is exposed to claims by third parties that may diminish its assets further before they can be distributed to creditors. Stakeholders may challenge a voluntary liquidation or petition to bring it under court supervision.
Court-supervised liquidationAt any time a voluntary liquidation may be brought under the court's supervision, which effectively makes the process equivalent to compulsory liquidation. This step will give liquidators greater powers and the ability to be recognised and gain assistance from foreign courts, as well as imposing a moratorium on claims by third parties. Bringing a voluntary liquidation under court supervision can be used to pre-empt creditors' petitions seeking compulsory liquidation.
Compulsory liquidationDue to their use of derivatives and leverage to magnify returns, hedge funds often have very significant creditors whose position is pivotal - they are often secured, and Cayman law allows them to exercise contractual self-help remedies. They also have priority over unsecured creditors in any liquidation.
It is often in the interests of such creditors to petition for the compulsory liquidation of a fund as soon as there is a default in payment to them, rather than acquiesce in any workout process seeking to recoup value for investors that risks further losses. Shareholders in an insolvent fund generally cannot petition, but redeemed investors may qualify as creditors and so can do so.
Pursuing a liquidation strategy rather than a conventional court action has advantages and disadvantages. One advantage is that liquidators have broad powers to recoup assets and restore value to a fund, including through claims against third parties. The results must be shared with other creditors, but so too are the costs.
Alternative remediesInvestors in insolvent funds may feel they have nothing to gain from any kind of liquidation process, as they stand behind creditors in terms of priorities. Their principal interest will be to recover compensation from those responsible for the insolvency, whether through liquidators' claims on the fund's behalf or by direct shareholder action. Investors holding 20 per cent of the shares may petition the court to appoint an inspector to investigate the fund's affairs who has broad powers to examine records and question directors. The inspector records their findings in a report to the court, which is made available to the petitioners and may be used as evidence in any subsequent proceedings. This can provide effective assistance to shareholders in insolvent funds who are considering litigation options.
These strategies are mutually exclusive and may be deployed in opposition to each other - a choice that best serves one party may be detrimental to another. Those who understand the options and have their own optimal strategies ready will gain a significant advantage. However, the hedge fund community can take comfort from the tools available under Cayman law that its court will ultimately be able to determine the fairest process for all concerned.
Jeremy Walton is a partner in the litigation practice group and head of the funds disputes team at Appleby in Cayman