The peculiar structure and dynamics of hedge funds create unique complexities for those responsible for their management when they enter the twilight zone of insolvency.
Those who mismanage funds incorporated in the Cayman Islands can expect legal repercussions. Cayman law does not proscribe fraudulent or wrongful trading, but there is a provision for liquidators to bring misfeasance proceedings against delinquent directors guilty of breaches of fiduciary duty, without the statutory defence provided by Section 727 of the UK’s Companies Act, whereby a court may excuse a director who has acted honestly and reasonably.
Cayman procedural rules also specifically allow the courts to exercise extraterritorial jurisdiction over non-resident directors of Cayman-registered funds. Against that background, this article seeks to assist those charged with managing a troubled fund through its final days.
Suspension of redemptions One of the first steps taken by a fund facing a serious and possibly terminal liquidity crisis is to suspend subscriptions and redemptions, effectively ceasing to trade. A review of the fund’s offering documents and articles should identify the threshold test for this action. Unfortunately, experience has shown that different language is used for different funds in the structure (not only onshore and offshore feeders, but possibly also between an offshore feeder limited company and a master fund limited partnership).
Investors who have been trying to redeem may challenge whether the test has been met. The investment manager’s recommendation that a fund take this step must therefore be adequately documented, along with the directors’ assessment that the test has indeed been met (with the benefit of legal advice where necessary).
Best practice dictates that the Cayman Islands Monetary Authority should be informed of a suspension (if a fund is regulated), as should the fund’s auditor. The suspension is likely to raise a going concern issue, which needs to be determined one way or another to the auditor’s satisfaction, and may require the last audit report to be revisited or supplemented.
Assuming that a suspension of redemptions does not achieve the desired objective and there are no prospects of resuming business, the directors must then consider liquidation options. These are generally (i) an informal winding down process managed by the investment manager, who requires constitutional change to alter the fund’s investment objectives and/or compulsory redemption of all investors; (ii) a shareholders’ voluntary liquidation, which may or may not involve court supervision of the liquidators; or (iii) a court petition for a compulsory winding up. The independent directors should instruct separate counsel in relation to this.
Consideration must be given to the relative merits of appointing a liquidator in a formal winding up, or a workout/ restructuring specialist for an informal winding down of the fund, as against this being undertaken by existing management. The latter may appear cheaper, but could also be inappropriate – any controversy surrounding the collapse of a fund will invariably require a professional insolvency practitioner to be appointed with court-sanctioned powers who can carry out an independent investigation into the causes of, and those responsible for, the insolvency.
Insolvency practitioners are used to managing the conflicts inherent in a master/feeder fund structure. However, separate liquidators are sometimes required, depending on the nature of the insolvency and its causes, and depending also on the stakeholders’ wishes.
Before any action is taken, the directors must determine who holds the fund’s voting shares – for example, the investors themselves, the manager or an affiliate, or even the trustee of an ‘orphan’ charitable trust. The directors should consider polling or otherwise informing investors whose shares are non-voting before they take action using their effective control of a fund’s voting shares. The presentation of any decision or recommendation by the board may be critical to its success – this is an objective for independent directors, since their views should not be tainted by self-interest.
The nature of hedge funds is such that a simultaneous ancillary liquidation process may well have to be initiated in other countries to safeguard assets held by custodians or prime brokers – New York, London, Geneva or Singapore, for example. This requires coordination of legal advice and court filings in these jurisdictions. As recent hedge fund cases in the New York Bankruptcy Court have shown, there may be difficulties in trying to make use of Chapter 15 of the US Bankruptcy Code, although other jurisdictions that have adopted the United Nations Commission on International Trade Law (Uncitral) model law on cross-border insolvency in whole or in part have taken a more liberal approach.
The board should consider taking pre-emptive steps, whether to improve the prospects of a liquidator obtaining recognition and assistance in other jurisdictions, or to minimise the challenges they will otherwise face in the absence of such recognition. It may therefore be advisable to transfer fund assets back to Cayman before initiating the liquidation process. This requires care – the duty of directors to act in the best interests of shareholders becomes subject to an overriding duty to have regard to the interests of the general creditors of a fund that is descending into insolvency. Some creditors may challenge such a transfer of funds if they feel it was done to frustrate their claims.
Once a fund is in liquidation, the investment manager and directors will have to cooperate with the liquidators, who have extensive powers to summon and examine the former management. Recognising that they are likely to be the first targets in litigation to recover or compensate for losses sustained by the fund, they should check their indemnities and any insurance cover, take separate legal advice and prepare themselves for claims.
Jeremy Walton is a partner and head of the fund disputes team at Appleby