Payments In Kind Must be From Fund's Assets at the Time Payment is Due
Re FIA Leveraged Fund (Unreported, Cayman Islands Court of Appeal, 18 February 2013)
Further to our update of 11 May 2012, the Court of Appeal has upheld the decision of the Grand Court ordering the winding up of FIA Leveraged Fund (the "Fund"), and in doing so has held that in order to constitute a valid in specie distribution to an investor, the asset being distributed must have been an asset in the fund's portfolio at the time when the investor was entitled to be paid their redemption proceeds.
The petitioners (three US pension funds) collectively invested US$100m in 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 certain of the petitioners. When they complained, and after the filing of a winding up petition, the Fund 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 petitioners proceeded with the petition to wind up the Fund on the basis that the SPV shares were insufficient to satisfy the amounts presently due and owing to the petitioners, such that the Fund was insolvent pursuant to section 92(d) of the Companies Law. Further, or in the alternative, that it was just and equitable that the Fund be wound up pursuant to section 92(e) of the Companies Law, in order that official liquidators could be appointed to investigate the Fund's affairs and take control of its assets. The Fund opposed the petition and argued that it had validly exercised its rights to pay redemption proceeds in kind pursuant to the constitutional documents and, in any event, that the value of the SPV shares was equal to the debt owed. It was further submitted that there was a genuine dispute on substantial grounds.1
The Decision at First Instance
The Grand Court performed a detailed analysis of the SPV shares and concluded that they had no real underlying value. It held 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. Accordingly, the Fund should be wound up pursuant to section 92(d) of the Companies Law. The court further held that it was clear, if viewed objectively, that the Fund could no longer achieve its purposes such that its substratum had failed and it should also be wound up pursuant to section 92(e) of the Companies Law.
Issues on Appeal
The Fund appealed the decision of the Grand Court.
The first question on the appeal was whether it was open to the Fund to satisfy the obligations arising out of the redemption requests by transferring the SPV shares to the petitioners – an issue which turned on whether the transfer was a "payment in kind" within the meaning of the Fund's articles of association and offering documents. If the transfer was held to be a payment in kind, the second question was whether it was open to the directors of the Fund to rely on their own valuation of the SPV shares as providing sufficient value to discharge the redemption obligations.
Issue 1: Was the Fund able to satisfy its redemption obligations by transferring SPV shares?
The Court of Appeal held that the first issue turned on the true construction of the Fund's articles and offering documents. Based on these documents, it was clear that a payment in kind (such as the transfer of SPV shares) had to be made from an asset from the Fund's portfolio at the time when the investor was entitled to be paid their redemption proceeds.2 In other words, it would not be open to the Fund, after the obligation to make payment of the redemption proceeds had arisen, to go out into the market and purchase some other asset which would then be used for the purposes of making an in kind distribution to the redeeming investor.
Examining the assets which were purportedly transferred to the investors, namely, the SPV shares, the Court of Appeal found that these were not assets of the Fund on the date on which the petitioners were entitled to be paid their redemption proceeds. Furthermore, they were not assets of anyone's at that date, as the SPV had not been incorporated, and therefore the shares did not exist. The Court of Appeal therefore concluded that the distribution of the SPV shares in satisfaction of the petitioners' redemption proceeds in these circumstances was impermissible and the appeal would be dismissed.
Issue 2: Was it open to the directors of the Fund to rely on their own valuation of the SPV shares?
Given the Court of Appeal's finding on the first issue, the issue of whether it was open to the Fund to transfer the SPV shares at the directors' own valuation did not need to be determined. However, the Court of Appeal went on to consider this issue anyway in the event that it was wrong on the first issue.
The Court of Appeal concluded that, in this case, it was not permissible for the directors of the Fund to rely on their own valuation of the SPV shares, for three reasons. Firstly, there was no evidence that the directors of the Fund had applied their minds to what the proper valuation of the SPV shares would be, and from the evidence it was clear that they simply adopted a valuation which had been reached by the investment manager, the master fund or another entity. Secondly, the only formal valuation put before the court to support the value at which the SPV shares were transferred was a valuation made 14 days after the date of the transfer, and therefore it was not a valuation which the directors could have had in mind at the date of transfer. Thirdly, two vastly different valuations of the SPV shares had been reached by the valuation specialist, based on the outcome of different scenarios unknown to the directors. The Court of Appeal stated that for the directors to adopt one value rather than the other in these circumstances could not be presented as a rational exercise of discretion. It was no answer to say that the directors had a complete discretion to value the Fund's assets as they saw fit as, "a decision maker's discretion in circumstances of this nature is limited as a matter of necessary implication by concepts of honesty, good faith and genuineness and a need for the absence of arbitrariness, capriciousness, perversity and irrationality". There was no evidence that the valuation of the SPV shares adopted by the directors had met these criteria. Accordingly, even if the Court of Appeal had been wrong in relation to the first issue, the appeal would still be dismissed on this ground.
The Court of Appeal's judgment confirms that it is the terms of a fund's articles of association and offering documents that determine the right of a fund to meet a redemption payment by way of a distribution in kind. Although each case will turn on its own facts (i.e. the specific contractual documents), in the absence of clear language to the contrary, the asset being distributed in kind must have been an asset in the fund's portfolio at the time when the investor was entitled to be paid their redemption proceeds. Further, whilst the directors can fix the appropriate value of the asset that is being distributed in kind, the directors need to ensure that the valuation of that asset is carried out in good faith, based upon a fair and transparent methodology.
1It 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.
2This is to be contrasted with the date at which the investor's redemption request has crystallised (often called the "redemption day" in fund documents), which is typically an earlier and distinct stage from the date that redemption payments are due to be made (see Culross Global SPC Ltd v Strategic Turnaround Master Partnership Ltd [2010 (2)] CILR 364). Certain passages in the Court of Appeal's judgment in Re FIA Leveraged Fund might be argued to conflate this distinction but, read as a whole, it appears clear that the relevant date in this case was the date the redemption payments were due to be made to the petitioners.