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Grand Court Examines Redemptions in Kind: Re FIA Leveraged Fund

2012年 5月 11日

Introduction

The Grand Court of the Cayman Islands has ruled that a redemption in kind of shares in an SPV capitalised with underlying fund assets was insufficient to discharge the redemption debt owed to redemption creditors1.  The decision does not call into question the familiar practice of a fund, liable to pay redemptions, forming an SPV in order to distribute its shares in kind by way of the discharge of debts due to redemption creditors2.  Instead, the Court paid close attention to the assets used to capitalise the SPV and ruled them3 insufficient to discharge the redemption debt.

This recent judgment in the matter of FIA Leveraged Fund (unreported, Grand Court, 18 April 2012) should be of particular note for funds and investment managers selecting assets used to capitalise SPVs to ensure that they have proper commercial value equivalent to the value of the redemption debt.

The petitioners (three US pension funds) collectively invested US$100m in the company (a feeder fund and referred to below as the "Fund") and sought to redeem their investment in 2011 in accordance with the Fund's constitutional documents.  The Fund's first attempt to meet the redemption request was to have the relevant master fund issue the Fund a promissory note payable in June 2012 which the Fund then assigned to the petitioners.  When the petitioners complained, and after the filing of the petition, the Fund then sought to redeem the petitioners in kind by way of shares in a Delaware LLC ("SPV") that had been capitalised by way of an assignment of a share purchase agreement granting options in relation to a US bank.  

The redemption in kind

The Fund's immediate master fund was invested in a Delaware company, which itself was invested in the ultimate master fund incorporated in Bermuda.  The Bermudian fund had entered into a share purchase agreement ("SPA") with United Community Banks Inc. ("UCBI"), a publicly traded company, granting to the Bermudian fund rights to purchase shares in UCBI (the "option").  Part of the SPA was assigned to the SPV, whose shares were ultimately distributed to the petitioners.  However, in order for the SPV to exercise the option, it would need to pay the exercise price of US$65m, which it had no means to pay.  In addition, the SPA was the subject of a dispute with UCBI over the exercise price following UCBI's five-for-one reverse stock split, notwithstanding the lack of a clause to that effect in the SPA and the inclusion of a clause which called for a corresponding reduction in the exercise price in the event of a stock split.

The Fund obtained an independent valuation report verifying that the value of the option (which was the SPV's only asset) was equivalent to the amount of the redemption proceeds due.  The petitioners rejected that valuation largely on the basis of UCBI's own valuation of the same agreement in their publicly available SEC filings.

Petitioners' case

The petitioners sought to wind up the Fund primarily on the basis of insolvency but also on just and equitable grounds.  The petitioners argued that: (i) the purported redemption in kind was worthless and therefore did not discharge the redemption debt; or (ii) on any view, it was obviously not worth the US$136 million owed.  The petitioners pointed to the various contingencies and variables surrounding the option, including the dispute arising from UCBI's reverse stock split and payment of the exercise price.

Fund's case

The Fund relied on there being a genuine dispute in the context of the Fund's constitutional documents permitting: (i) the redemption of shareholders' investments by way of redemption in kind; and (ii) the Board of Directors in consultation with the Investment Manager "in its sole discretion" being empowered to determine the value of the assets forming the redemption in kind.  In addition, the Fund also commissioned (and submitted in evidence) an independent valuation report to support its contention that the value of the option was equal to the debt owed.  The Fund argued that it had validly exercised its rights pursuant to the constitutional documents and the petitioners were in no doubt as to how redemptions in kind operated in this context.  It was further submitted that there was a genuine dispute on substantial grounds4.

Judgment

The Court performed a detailed analysis of the option and concluded that it had no real underlying value.  It was held that that there was no genuine dispute as to whether or not the petitioners had received a redemption in kind that realistically represented the value of their debt, such that the Fund was held to be insolvent.  The Court agreed with the petitioners that there were too many uncertainties and variables surrounding the option (including payment of the exercise price of US$65 million and litigation concerning the effect of UCBI's reverse stock split on the SPA).  In the Cayman Islands, the applicable test for solvency is the present ability of the company to pay its debts as they fall due (i.e. the "cash flow" test) and it was held that the Fund could not currently do so and therefore should be wound up.

In its analysis, the Court considered the question of why the directors had selected the option to effect the redemption in kind.  The directors were entitled to do so under the Fund's constitutional documents, however, it was questioned whether their selection was consistent with a bona fide exercise of their discretion.  The Court held that the directors could not choose assets that could not reasonably be expected to give commercial efficacy to the contractual obligations (arising from the Fund's constitutional documents) owed by the Fund to the Petitioners.  In other words, the Fund could not transfer what the Court held to be "commercially worthless" assets as a redemption in kind.

With respect to the just and equitable grounds, the Court further held that it was clear, viewed objectively, that the Fund could no longer achieve its purposes such that its substratum had failed and it should also be wound up on that basis alone5.  

Conclusion

The judgment underlines that it is the terms of a Cayman Islands fund's articles of association (and offering memorandum where applicable) that determine the rights of the fund and its investors.  It was not in dispute that the Fund was entitled to meet a redemption payment by way of distribution in kind.  However, critical in the Court's decision to wind up the Fund was its conclusion that the assets the Fund purported to transfer were not worth the redemption debt.  

The winding up order has been appealed.

Please click here to download the full judgment.

1i.e. former shareholders who have validly redeemed and are awaiting payment of redemption proceeds.

2In our view, the judgment would be equally applicable to a direct redemption of assets and is not only limited to redemptions by way of transferring SPV shares.

3And by extension the SPV shares, the value of which was derived from such assets. 

4It is a general principle of insolvency law that a winding up petition should be dismissed where there is a bona fide dispute over the debt owed or whether it has been discharged.  The Fund's case was that, at the very least, the dispute should be tried by way of an ordinary Writ action and not in the context of a winding up petition. 

5The Court held that the Fund could be wound up on the basis of the "more established" loss of substratum case of Re Suburban Hotel Company (1867) LR 2 Ch App 737 or, alternatively, on the basis articulated in Re Belmont Asset Based Lending Ltd [2010] 1 CILR 83.  The Court avoided formally endorsing the latter judgment, which has been the subject of considerable debate. 


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