2 May 2011
Stephen Moverley Smith QC examines some recent cases involving fund investors’ redemption rights that reveal a BVI-Cayman split
In the middle of the last decade it was all the rage to invest in exotic hedge funds that often speculated on a global basis in distressed companies, distressed debt and developing technologies.
The vehicle of choice for these funds was an offshore openended investment company, generally incorporated in either the Cayman Islands or the British Virgin Islands (BVI). Investments took the form of redeemable non-voting shares that were subscribed for and subsequently redeemed at a price determined by reference to the company’s net asset value (NAV).
While the underlying investments were generally long-term and illiquid, in an era when credit was cheap and freely available funds had little difficulty in raising the money needed to pay redeeming investors.
All this, of course, changed in the wake of the collapse of Lehman Brothers. New subscriptions dried up, along with credit. Faced with this crisis many funds sought to implement provisions found in companies’ subscription agreements or articles enabling calculation of the NAV to be suspended, and with it the redemption process.
Investors, many of whom had parted with tens if not hundreds of millions of dollars in the belief that they could redeem at will now found themselves locked into speculative investments for an indefinite period of time, during which the fund managers, who continued to manage the underlying assets, naturally continued to draw fees.
In some cases redemption requests had been accepted and NAVs declared (thus fixing the redemption price), but the funds found themselves without the ability to make the requisite payments. This appeared to give investors the chance to seek winding-up orders on grounds of insolvency.
In Cayman some clarification was given as to the point when a redeemer becomes a creditor and thus can petition to wind up. In Culross Global SPC Ltd v Strategic Turnaround Master Partnership Ltd (2010) the Privy Council decided that it all depended on the articles. For a time it appeared that the approach taken there was mirrored by that taken in the BVI.
However, in the BVI a niggling issue had arisen about the meaning of ’creditor’ for the purpose of establishing jurisdiction to wind up: the BVI Insolvency Act 2003 excluded from the definition claims made by a member in their character as a member. Did redeemer claims fall into this category?
The BVI courts at first instance on three occasions held that it did, but the fund in the last of these cases, Westford Special Situations Fund, challenged that finding on appeal. In a robust judgment the Eastern Caribbean Court of Appeal overturned the winding-up on a number of grounds, crucially including a determination that unpaid redeemers did not have locus to seek a liquidation as creditors.
What a wind-up
While Westford has provided funds in the BVI with some welcome relief not available to their cousins in Cayman, the divergence of approach has become more stark over the vexed question of whether a member can seek the winding-up of a fund on the grounds that it has lost its ’substratum’. The principle, developed in the 19th century when single-object companies were commonplace, traditionally requires that fulfilment of the purpose for which the company was formed has become impossible.
In Cayman, in Re Belmont Asset Based Lending, an attempt was made to rely on this doctrine by the members of a failed fund. Although the application to wind up was in the event uncontested, the judge seized the opportunity to promote a novel test of viability, applicable seemingly only to openended investment funds. As Mr Justice Jones saw it, whenever it was proved that such a fund was no longer viable as such, the Cayman court ordinarily would wind it up.
In a series of subsequent cases, all of which came before Jones J, the judge found no difficulty in following his previous decision in winding up funds he saw as no longer viable.
It was only a while after Belmont that the issue surfaced in the BVI in Re Quantek Opportunity Fund. The fund members sought to rely on the Belmont viability test, but found an unsympathetic tribunal in Mr Justice Bannister, who, recognising that Belmont represented a radical departure from principle, preferred instead to apply established English principles. He suggested that he, unlike Jones J, had the benefit of full argument on the point.
This gave funds in Cayman some heart, but when one sought to rely on Quantek before Jones J in another case, Re Heriot African Trade Finance Fund, it was given short shrift. Jones J said that if Quantek represented the law in BVI, then BVI law differed from Cayman law on the point. This was a slightly surprising conclusion given that both Jones J and Bannister J claimed to be applying established legal principles.
A resolution of this polite judicial stand-off will have to await an appeal in an appropriate case to a higher court. Meanwhile, the BVI can fairly claim to be the more friendly jurisdiction for hard-pressed funds.
Stephen Moverley Smith QC of XXIV Old Buildings was counsel for the successful funds in Westford and Quantek