A Little More on the Side
Jones J's recent decision in Swiss-Asia Genghis Hedge Fund v Maoming Fund (Grand Court, 24 July 2013) provides a useful illustration of the Cayman court's willingness to give effect to appropriate fund side letters, where such deals are made in accordance with the relevant governing documents. A copy of the judgment can be found here.
This judgment also helpfully clarifies the effect of Quin J's recent dicta in Medley Opportunity Fund v Fintan relating to side letters to which the custodian and member of record is not expressly a party.
The Maoming Fund (the "Fund") was an open-ended fund incorporated in the Cayman Islands. Swiss-Asia Genghis Hedge Fund ("Swiss Asia") was the beneficial owner of shares in the Fund. However, those shares were recorded on the Fund's register of members in the name of a custodian, Somers Nominees (the "Custodian").
In August 2011 the Custodian delivered a redemption request to the Fund, which required all its shares to be redeemed on the next dealing day, which was 3 October 2011. On 26 October 2011, after that redemption request matured but before any payment had been made, the directors of the Fund suspended subscriptions and redemptions. By that point the Custodian had become a creditor of the Fund for some $1.7 million – although they were informed that, because the Fund was experiencing acute liquidity difficulties, the payment of those proceeds would be delayed.
Investors in the Fund (including the Custodian) were offered various options as to how they might go forward. These included redemptions in specie, receiving redemption payments in cash on a delayed basis, or "re-subscription" into the Fund. There then followed a negotiation between Swiss Asia and the Fund. This resulted in a letter agreement, written on the letterhead of Swiss Asia's manager on behalf of Swiss Asia, addressed to the Fund and countersigned by its directors. The Custodian did not sign the letter agreement. In essence, that letter agreement envisaged that (a) Swiss Asia would "cancel the redemption request placed in the registered name of [the Custodian]"; and (b) the Fund would commit to "re-purchase" the shares over a prescribed timetable at the relevant NAVs. In order to give effect to this deal, the directors of the Fund resolved to issue new shares to the Custodian on the January 2012 dealing day at the September 2011 NAV, in consideration for the Fund being released from its obligation to pay the original redemption proceeds. Although the Fund started to perform its side of the letter agreement by purporting to redeem these shares in February, March, April and May, it only paid $50,000 of the proceeds.
The Custodian subsequently assigned the right to receive the redemption proceeds under the letter agreement to Swiss Asia. Swiss Asia then sued to enforce the letter agreement and recover the debt it said it was owed pursuant to it.
The Fund argued that it was not bound by the letter agreement (and instead was entitled to pay the Custodian with an in specie distribution), either because (1) the "cancellation" of the October redemption was invalid as being beyond the power of the directors; and/or (2) the letter agreement was not binding or enforceable, having not been entered into by the Custodian as shareholder of record. Both arguments failed.
Was the October Redemption capable of being "cancelled and reversed"?
The Fund argued that, as a matter of law, once a redemption request has taken effect and the shares have been cancelled, the directors have no power to reverse the transaction and put the parties back in their original position. Jones J did not accept that proposition. He noted that by the Articles the directors were given "the widest possible powers to manage its business", which included "the power to agree with any counter-party that a contract shall be varied, rescinded, cancelled or discharged and replaced with a new one. It follows that the directors will have power to cancel a subscription or redemption of shares unless, upon a true construction of [the Articles dealing with subscriptions and redemptions], their general power is restricted".
Jones J also appeared to acknowledge that in fact, the Fund was not "cancelling" the redemption in the sense of treating it as though it had never happened. Rather, it was formally structured as a re-subscription in January, albeit priced so as effectively to achieve the same commercial result as if the original redemption had not occurred. As the Judge noted "the more difficult question [was] whether they were entitled to do so at the September NAV rather than the current December NAV".
The Judge held that they were. The relevant Article provided that "generally" shares would be offered at the NAV prevailing on the last valuation day, but that "the Directors may waive or modify the subscription or redemption provisions of these Articles … for a specific transaction". Taken together, these provisions gave the directors the power to depart from the normal regime, and they were empowered by the Articles to cause the Fund to enter into the letter agreement.
Importantly, this case is not authority for the proposition that funds may retrospectively alter shareholder registers and/or "reverse" redemptions, so as to undo what has been done. That is not what happened here. What this case does demonstrate, though, is that depending on the terms of the governing documents and with careful structuring, in the right circumstances it may be possible to achieve effectively the same commercial result.
Was the letter agreement binding and enforceable, even though it wasn't signed by the shareholder of record?
The Fund further argued that the letter agreement constituted a contract only between Swiss-Asia and the Fund, which is not capable of conferring any rights on the Custodian as the shareholder of record. The Fund relied on the 2012 decision of Quin J in Medley Opportunity Fund v Fintan as authority for the proposition that any contract relating to shares in a company or rights arising out of a shareholding will be unenforceable unless the registered holder is party to the contract.
Jones J rejected those arguments, saying that the Medley decision did not go that far (and was in any event distinguishable on its facts). While Jones J was careful not to undermine the important principle that companies need not look behind their registers, he went on to say that they could, if they wanted, deal with beneficial holders. He said:
"Clearly, the Fund was entitled to insist that [the Custodian] be made a party to any contract relating to the October Redemption, the redemption proceeds or any re-subscription for shares in consideration for the release of the debt due from the Fund. There are sound policy reasons for the well-established common law rule that a company is not bound to deal with anyone other than the registered owner of shares and this rule is reflected in the Fund's articles of association … Whilst the Fund was not bound to deal with Swiss-Asia, it was perfectly entitled to do so. There is no rule of law which precludes the Fund from dealing directly with its investors rather than the custodians in whose name their shares were registered. Any such rule would be wholly impractical and inconsistent with commercial practice as reflected by what took place in this case."
Jones J held that the letter agreement was valid and bound the Fund for two separate reasons:
Firstly, the Judge applied an agency analysis. He held that, in engaging in the negotiations, Swiss-Asia impliedly represented that it had a contractual right to give the Custodian instructions in respect of this shareholding. Jones J said "Although the Fund is entitled to treat [the Custodian] (and only [the Custodian]) as its shareholder, it is perfectly entitled to negotiate and contract with someone who has apparent authority to act on behalf of [the Custodian] in respect of the shares if it chooses to do so". An arrangement of this sort, said Jones J, "are matters which invariably fall within the scope of a securities custody agreement". Although not saying so in terms, Jones J appears to have found that the Custodian as custodian was in fact a party to the letter agreement, even if not expressly, because Swiss Asia was acting as its agent.
Secondly, Jones J held that an estoppel by convention operated so as to prevent the Fund from denying it was bound by the agreement. This is based upon the proposition that it is just that the parties to a transaction be precluded from denying what has been assumed between them as an essential factual basis. Here, Jones J said, Swiss Asia and the Fund had agreed to assume that the letter agreement would be binding and enforceable notwithstanding that the shares had been registered in the name of the Custodian. It was also relevant that the Fund had partially performed on the letter agreement by effecting a number of redemptions at the start of 2012, and making a partial payment. Jones J held "It would be unjust to allow the Fund (or Swiss Asia) to walk away from their obligations simply because they chose not to make the registered shareholder a party to the letter agreement".
This case provides a useful counterpoint to the recent decisions of Quin J in Medley and in Matador dealing with side letters. As we noted when commenting upon Medley in our update of 30 August 2012, that case did not seek to lay down a blanket rule that arrangements with investors will be unenforceable if not signed by the member of record. Usually, a carefully structured arrangement of this nature will expressly involve the custodian (if only to obviate the need to have these kinds of arguments later). However, depending on the facts of any particular case, principles of agency and estoppel may operate to avoid commercially unreasonable results.