The volatility of the US sub-prime lending market has highlighted the need for offshore funds to be truly offshore. By Sam Shires and Erin Gray

Ensuring that an offshore investment fund is truly managed offshore has always been an important factor for tax reasons, but in these times of turbulent markets the location of the management and administration of the fund is also becoming an important factor for worst-case scenario purposes and the possible liquidation of the fund.

The turmoil brought to world financial markets by the so-called ‘credit-crunch’ has seen several cases of cross-border insolvency involving offshore investment funds come into the spotlight. Because these types of funds tend to be vehicles established in an offshore jurisdiction for tax neutrality reasons, but managed and sold to investors onshore, the obvious dilemma is which jurisdiction’s law should be applied to the liquidation of the fund’s assets.

The US and England have adopted the UNCITRAL Model Law on Cross-Border Insolvency to deal with these situations. This introduces the ‘centre of main interests’ (Comi) concept. If the Comi is deemed to be offshore then the court will recognise the offshore liquidation proceedings as foreign main proceedings under US or English law. The importance of this recognition is that foreign main proceedings attract an automatic stay of execution against creditors’ claims under the Model Law, which is attractive to the fund manager.

Bear Stearns

The two main cases to deal with this issue have both arisen in the US. The most recent, the Bear Stearns cases, concern two funds which were both Cayman Islands companies with registered offices in the Cayman Islands.

A Massachusetts corporation acted as administrator of the funds, and as well as carrying out day-to-day administration services acted as registrar and transfer agent and provided accounting, clerical, shareholder register, investor relations and distribution services. The funds’ books and records were maintained and stored in Delaware by the administrator.

Bear Stearns Asset Managements, a US corporation, acted as the investment manager for the funds and the assets managed by it were located in New York. All other assets were located in the US (although subsequent to the filing of the liquidation proceedings substantial funds were transferred to accounts in Cayman).

The funds began to suffer a significant devaluation of their asset portfolios following the volatility in the US sub-prime lending market. The funds’ boards filed petitions seeking winding up orders in Cayman and for the appointment of local liquidators. The orders were granted by the Cayman courts and the liquidators filed petitions pursuant to the US Bankruptcy Code for orders recognising the liquidation of the funds in the Grand Court of the Cayman Islands as foreign main proceedings in the US.

The Bankruptcy Code incorporates the Model Law, and provides further that “in the absence of evidence to the contrary, the debtor’s registered office… is presumed to be the centre of the debtor’s main interests”. This is often referred to as the ‘Comi presumption’.

The court in the Bear Stearns case looked to UNCITRAL for guidance on the Comi. In the regulation adopting the EU Convention the Comi is referred to as “the place where the debtor conducts the administration of his interests on a regular basis and is therefore ascertainable by third parties”. It was noted that the Comi presumption may be overcome “particularly in the case of a ‘letterbox’ company carrying out any business in the territory of the member state in which its registered office is situated”.

The court was quick to seize the fact that all the administration and management of the funds took place in the US, that the assets of the funds were physically located in the US and that the funds’ only connection with Cayman was that they were registered there; in effect they were letterbox companies. As a result, the Comi presumption was held to be rebutted.

In a further blow, the court rejected an alternative application to recognise the Cayman liquidation proceedings as foreign ‘non-main’ proceedings, deciding that the funds did not even have an ‘establishment’ in Cayman.

Policy considerations must have weighed heavily on the court’s decision. With most of the investors located in the US it would have been brave to recognise the Cayman liquidation proceedings, particularly, as some have suggested, given the less favourable rights of the funds’ creditors and investors under Cayman law.

The Bear Stearns judgment differs from the decision in the other main case to have considered the issue, SPhinX [2007]. In that case it was stated that if the parties had not objected to the Cayman Islands proceedings being recognised as foreign main proceedings, recognition would have been granted on the sole grounds that no party objected and no other proceeding had been initiated elsewhere. In SPhinX the court refused ‘main’ status largely on the basis of the bad faith motives of those who brought the Cayman proceedings.

The Basis Yield Alpha Fund

Another recent case concerns the Basis Yield Alpha Fund, also a casualty of the US sub-prime lending market. Sydney-based fund manager Basis Capital has put the fund into provisional liquidation in the Cayman Islands. The liquidators have taken action in both the US and England to protect the remaining assets of the funds.

It has been reported that an order recognising the Cayman Islands liquidation as the main proceedings was issued by England’s High Court of Justice Chancery Division Companies Court. A possible factor in this decision is that it is understood that the Basis Fund carried out more of its administration in the Cayman Islands. Also, apparently 10.5 per cent of the fund’s beneficial investors are in the Cayman Islands. However, the fund will have to overcome the Bear Stearns and SPhinX cases in order to succeed in the US.

Sam Shires is a group partner and Erin Gray is an associate at AO Hall