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Heralding Investor Certainty

2015年 6月 30日

A recent decision of the Grand Court, Primeo Fund (in official liquidation) v Herald Fund SPC (in official liquidation)1, is another win for investor certainty in the Cayman Islands.  In previous updates, we have written about Cayman Islands and BVI decisions which illustrate the various challenges associated with bringing clawback actions in the Cayman Islands against innocent arm's length mutual fund investors who have validly redeemed their shares. That message has been further reinforced, on different grounds, by Jones J in Primeo v Herald

In particular, the Grand Court has determined that: (a) liquidators cannot rely on section 37(7)(a) of the Companies Law (2013 revision) (the "Law") to alter the rights of investors that redeemed prior to the liquidation; and (b) a restatement of NAV by a liquidator under section 112 of the Law, in cases where a company has been the victim of a fraud, can only operate to vary the rights of investors who remain as members (i.e. shareholders) and will not impact on the rights of investors that have redeemed even if those redeemers have not yet been paid.   

Prior to its liquidation, Herald Fund SPC ("Herald") had invested substantially all of its assets in Bernard L Madoff Investment Securities LLC.  The Primeo Fund ("Primeo") had, in turn, invested in Herald and as a result was an indirect victim of the Madoff Ponzi scheme.  

Various investors, including Primeo, had submitted redemption requests to Herald for a redemption date of 1 December 2008 – i.e., before the Madoff fraud came to light on 11 December 2008.  Herald acknowledged that, pursuant to the terms of its articles of association, those redemption requests had crystallised and the investors had been redeemed as at 1 December 2008 ("December Redeemers").  However, apart from one investor, none of the December Redeemers had been paid their redemption proceeds before Herald went into liquidation on 23 July 2013. 

Against that backdrop, the first issue which fell for determination ( the "Redemption Issue") was whether the December Redeemers should be treated as not having redeemed because their redemption proceeds were not paid and remained outstanding at the commencement of the liquidation, as a result of section 37(7)(a) of the Law. 

Separately, the Grand Court also went on to consider whether: 

(a)  the Herald NAVs, that had been calculated during the lifetime of the fund, were not binding on Herald and its investors as a result of the Madoff fraud pursuant to section 112 of the Law and Order 12, rule 2 of the Companies Winding Up Rules ("Rule 2"); and

(b)  section 112 of the Law and/or Rule 2 apply so as to require or empower the Herald liquidator to restate the NAV and rectify the register of members; 

(together the ("Rectification Issues"). 

The Redemption Issue 

Section 37 of the Law sets out, among other things, the manner in which a company can issue and redeem redeemable shares.  It is, as Jones J confirmed, a "comprehensive code" for that purpose. 

In particular, section 37(3)(c) provides that redemption of shares may be effected in such a manner and upon such terms as may be authorised by or pursuant to a company's articles of association.  The meaning of this section was considered by the landmark decision of the Privy Council in Strategic Turnaroundwhen answering the question of when a member is considered to have been redeemed.  The Privy Council held that when a redemption was deemed to take place would depend on the terms of the relevant articles of association.  

Since that decision, the generally accepted position has been that a member did not remain a member simply because it had not received its redemption proceeds where the terms of the relevant articles provided that the redemption request takes effect at an earlier date and, that as at that date, the investor ceases to be entitled to any rights as a member. 

However, the decision in Strategic Turnaround did not give any guidance as to the meaning of section 37(7)(a) of the Law.  The meaning and applicability of this section is unclear and has not been the subject of any reported judicial consideration until now, notwithstanding that similar provisions appear in the companies laws of other common law jurisdictions.  

Section 37(7)(a) provides as follows: 

"Where a company is being wound up and, at the commencement of the winding up, any of its shares which are or are liable to be redeemed have not been redeemed or which the company has agreed to purchase have not been purchased, the terms of redemption or purchase may be enforced against the company, and when shares are redeemed or purchased under this subsection they shall be treated as cancelled: Provided that this paragraph shall not apply if- 

(i)  the terms of redemption or purchase provided for the redemption or purchase to take place at a date later than the date of the commencement of the winding up; or

(ii)  during the period beginning with the date on which the redemption or purchase was to have taken place and ending with the commencement of the winding up the company could not, at any time, have lawfully made a distribution equal in value to the price at which the shares were to have been redeemed or purchased." (emphasis added) 

Primeo's position was simple: section 37(7)(a) of the Law only applied to shares which had not been redeemed as at the commencement of a liquidation.  Accordingly, the section had no application in this case because, pursuant to the terms of Herald's articles of association, the December Redeemers had been redeemed as at 1 December 2008.  

In light of the Privy Council's decision in Strategic Turnaround, Herald was bound to accept that Primeo had ceased to be a member and had become a creditor on 1 December 2008.  However, Herald argued that, for the redemption process to be completed in the context of section 37(7)(a), the member needed to have actually received payment of the proceeds.  Herald's argument was that the meaning of "redemption" under section 37(7)(a) was different from the meaning of "redemption" in the context of a company's articles of association and the terms of section 37(3)(c) as considered in Strategic Turnaround.  If Herald's position was correct, there would be scope for stakeholders like Primeo (whose redemption requests had crystallised prior to liquidation) to be "dragged back" into the general pool of members who had not redeemed. 

The Grand Court refused to accept Herald's argument and held that the legislature must have intended to use the term "redemption" consistently throughout section 37.  In the absence of clear language to the contrary, there was no reason why "redemption" should require payment of redemption proceeds for the purpose of section 37(7)(a) but not for section 37(3)(c).  As such, the Grand Court held that once an investor had been redeemed in accordance with a fund's articles of association prior to the liquidation, the section did not apply. 

The Grand Court went on to give some guidance as to when section 37(7)(a) could be relevant, saying it would apply in two different scenarios: (a) in the case of shares which "are to be redeemed" but have not been redeemed (e.g. where a company's shares were required to be redeemed as at a fixed date); and (b) in the case of shares which are "liable to be redeemed" (e.g. where a valid redemption notice has been served but the steps required by the articles of association in order to complete the redemption have not been completed prior to the liquidation).  In those circumstances, the Grand Court considered that the obligation to redeem the shares could be enforced against a company in liquidation unless the enforcement was disallowed by the provisos in subsections 37(7)(a)(i) and (ii).    

It should be noted that it is difficult to see how the first scenario could ever trigger the operation of the section because either (i) the fixed date will have occurred prior to the liquidation, in which case the member will have redeemed and, at least according to the Grand Court in this case, the section will not apply; or alternatively (ii) the fixed date will not be due to occur until after the liquidation, in which case the section will not apply by virtue of section 37(7)(a)(i).  

It also seems that the second scenario will very rarely occur in the Cayman Islands.  Typically (and as was the case both here and in Strategic Turnaround) a fund's articles of association provide that once a particular date has passed, the investor has no further rights as a member and only retains the right to receive his redemption proceeds.  In that case, as Jones J confirmed, the investor will have been redeemed and section 37(7)(a) does not apply.  It is rare that articles make the completion of administrative steps a prerequisite to redemption.  

The Rectification Issues 

Where a fund is undergoing a solvent liquidation, Section 112(2) of the Law gives a liquidator the power in certain circumstances to rectify the register of members thereby adjusting the rights of members amongst themselves. 

Rule 2 provides that the liquidator must exercise this power where the company has issued or redeemed shares at prices based upon a mis-stated NAV "which is not binding upon the company and its members by reason of fraud or default". 

In this case, Herald argued that as a result of the Madoff fraud, none of the NAVs that had been calculated since the incorporation of the fund were binding and therefore the liquidator was obliged to restate the NAV and rectify the register. 

The Grand Court disagreed and considered that the mandatory provisions of Rule 2 did not apply in the cases of "external" fraud (i.e. where the fund was a victim of the fraud) but only in the case of "internal" fraud (i.e. where the fund or its agents perpetrated the fraud).  In other words, there needed to be some conduct on the part of the fund or its agents that would have the effect of vitiating the contract between the fund and its members such that the NAV could not be considered to be binding.  In those circumstances, the liquidator would be obliged to restate the NAV and rectify the register.  However, where the NAV was binding in accordance with the articles, Rule 2 did not operate to make the NAV retrospectively subject to a mandatory restatement as a result of subsequent, external events.  

Having reached this conclusion, the Grand Court turned to consider whether the Herald liquidator still had the power under section 112 of the Law, as opposed to the obligation under Rule 2, to rectify the register.  The Grand Court found that the language used in section 112 was unqualified and was not limited by Rule 2.  Accordingly, the Herald liquidator had a discretion but not an absolute obligation to seek to rectify the register as a result of the Madoff fraud.  Whether the Herald liquidator will be granted leave to exercise this power and what valuation methodology should be used has been left open until the next hearing.    

Importantly, the Grand Court confirmed that the power to rectify the register in the context of an external fraud was only limited to rectifying the positions of members at the date of the liquidation.  It seems clear that Jones J considered that, as investors who had redeemed prior to the liquidation were no longer members, any rectification of the register could not affect their right to be paid as creditors (or, it would follow logically, operate to create a right to claw back redemption proceeds).  

Moreover, and although the Grand Court did not specifically address the point, it also seems to follow that this analysis applies in the context of an internal fraud, when Rule 2 is engaged.  The language of section 112 of the Law clearly refers to the rectification of the "register of members" and the adjusting of rights of "members amongst themselves".  It would not seem to be within the scope of the section that a liquidator could seek to alter the rights of investors that had redeemed, and as such were no longer members, even in cases of internal fraud.  As subsidiary legislation, the scope of Rule 2 cannot validly exceed the scope of section 112.  

Finally, it should be noted that one point which was not addressed is whether there is any scope for the court to dis-apply the apparently mandatory provisions of Rule 2 where, notwithstanding an internal fraud, it would be uneconomical, impractical or otherwise not sensible for the liquidator to restate the NAV and rectify the register. 

Conclusion 

This decision brings clarity to some longstanding uncertainties about how the above provisions of the Law should be interpreted and applied in practice.  It will also bring some further welcome certainty for investors who redeemed shares prior to liquidation, and who have been concerned about the risk of being dragged into a clawback or priorities dispute with a fund's liquidator.


Grand Court, unrep. 12 June 2015, Justice Jones. 

See Fairfield Sentry v Quilvest Finance Ltd [2014] UKPC 9 and RMF Market Neutral Strategies (Master) Limited v DD Growth Premium 2X Fund (Unreported, 17 November 2014).

Culross Global SPC Limited v Strategic Turnaround Partnership Limited [2010] 2 CILR 364.


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