Herald Fund SPC: The NAVs That Bind
In a decision that does much to reassert legal certainty for investors in Cayman Islands funds the Cayman Islands Court of Appeal ("CICA") has overruled a decision of the Grand Court concerning the circumstances in which an official liquidator of a solvent company could rectify the register of members, in In the matter of Herald Fund SPC (in official liquidation).
The Grand Court had held that section 112(2) of the Companies Law ("section 112(2)") empowered an official liquidator to go behind a contractually binding (but misstated) NAV and substitute a correct NAV in its place. The CICA disagreed and, while noting the potential for harsh and indeed arguably unfair outcomes for some investors where a binding (but misstated) NAV was upheld, preferred to uphold the principle of legal certainty for all investors, and followed the recent line of authority from the Privy Council decisions in Fairfield Sentry and Pearson v Primeo.
Herald Fund SPC ("Herald") was a Madoff feeder fund. Primeo Fund ("Primeo") was a shareholder in Herald. Both Herald and Primeo are subject to solvent, court supervised, Cayman Islands liquidation proceedings.
Primeo's investment in Herald was valued at approximately US$465 million (the contractually binding NAV, albeit based on the fraudulent and fictitious figures generated by Madoff's company, BLMIS). The value of Herald's claim in BLMIS' US Bankruptcy Proceedings (attributable to Primeo's investment in Herald) was approximately US$149 million (calculated on the basis that a BLMIS customer could not recover fictitious profits appearing in its last statement of account – effectively an adjusted NAV). Herald's liquidators sought to adjust Primeo's entry in the register of members to reflect a subscription based on the value of Herald's claim against BLMIS and not the contractually binding NAV.
Cayman Islands Legal Provisions in Play
The CICA's decision turned on the wording of section 112(2) and Order 12, rule 2 of the Companies Winding Up Rules ("Order 12, rule 2").
Section 112(2) of the Companies Law grants a liquidator of a solvent company the power to "settle and, if necessary rectify the company's register of members, thereby adjusting the rights of members amongst themselves".
Order 12, rule 2 provides that a liquidator shall exercise his power to rectify the company's register of members under section 112(2) if, among other things, he is satisfied that "the company has from time to time issued redeemable shares at prices based upon a mis-stated net asset value which is not binding on the company and its members by reason of fraud or default…" [emphasis added].
Liquidators' Power under Section 112(2)
Section 112(2) did not give a liquidator the power to adjust the register of members to deprive a person of accrued legal rights. The intention of section 112(2) was not "to create a power to calculate a correct NAV and substitute it for the incorrect NAV which has, despite its incorrectness, been calculated in accordance with the member's contractual rights. As Primeo has submitted it could not have been the intention of the legislature to confer a discretionary power upon a liquidator to deprive a person of his accrued legal rights." Key in the CICA's reasoning was the use of the word 'rectify' in section 112(2), this was to be given its traditional narrow meaning in the statutory context of the Companies Law in which it appears.
The purpose of section 112(2) is to adjust the rights of members for the purpose of correcting an incorrect NAV in accordance with the rights of shareholders (i.e. rectification of the register needs to be made within the four corners of the articles – see further below). Section 112(2) may also be in contemplation of a NAV that has been calculated and which is contractually binding and for some reason the register of members shows more or less shares than a member's legal entitlement (i.e. correcting a mistake to the register and not to the NAV itself).
Section 112(2) has been given a narrow meaning by the CICA which assists in providing legal certainty for investors in Cayman Islands funds.
How does section 112(2) relate to Order 12, rule 2?
Section 112(2) creates the power for the liquidator of a solvent company to rectify the register of members. Order 12, rule 2 sets out the circumstances in which the liquidator can exercise the power. If the NAV is not correct and not binding on the company or the shareholders, the rule gives effect to the power in the principal statute to achieve justice for shareholders through a determination by the liquidator and, if necessary, the court in place of what could be a multiplicity of actions by individual shareholders to enforce their legal rights arising out of the fraud or default.
When can a liquidator of a solvent company rectify the register of members and adjust the rights of members amongst themselves?
As set out above, where the NAV is not correct and not binding, section 112(2) gives the liquidator power to correct the register. Whether a NAV is contractually binding or not will depend on the terms of the articles of association, and on the specific factual scenario in each case. It remains to be seen if the fraud or mistake must be by the fund, or by a third party, whether connected to the fund or otherwise.
It also remains to be seen in what other circumstances section 112(2) might be invoked, in particular where there was a binding NAV. A mistake in the register that did not impact on the NAV or a manifest arithmetical error (in, say, date entry) that did impact on the NAV directly are two possible scenarios. However, the dicta of the CICA and the Privy Council in the cases to date do not reflect a strong judicial appetite for reopening NAVs in any circumstances.
Section 112(2) does not have any application to insolvent companies, for which the register can be rectified (where required) under section 46 of the Companies Act.
Issues relating to investors in funds generated by the BLMIS and Weavering frauds will continue to occupy the courts. The Weavering preference action against redeemed investors will be heard by the Privy Council in June 2018. It is not yet clear whether there will be an appeal to the Privy Council of the CICA's decision in Herald, but in the meantime, the clear trend is legal certainty in the calculation of NAVs, or as the Privy Council put it in Pearson v Primeo, "the tree must lie where it falls."