Road to Redemption: Cayman Islands Hedge Fund Insolvencies at the Privy Council in 2017

For the Cayman Islands insolvency community, 2017 could fairly be called the Year of the Redeeming Shareholder. The Judicial Committee of the Privy Council, the ultimate appeal court for Cayman and several other important offshore jurisdictions, delivered two judgments originating from the Cayman Islands this past year. Both cases involved litigation between court-appointed liquidators of insolvent hedge funds and investors in those funds who had redeemed their shares in the fund before the liquidations. Although the issues at play in each were different, both decisions demonstrate and reinforce the favourable approach to redeeming shareholders found in Cayman corporate insolvency legislation and policy.

Cayman-incorporated hedge funds typically set redemption dates on a quarterly or monthly basis to allow investors to withdraw funds. On each redemption date, those investors who provided a redemption notice within the applicable time period will have their shares redeemed, cease to be shareholders with respect to those redeemed shares, and be entitled to payment from the fund of the value of those shares, which is generally calculated by reference to the fund’s net asset value. The fund usually has a grace period of up to 30 days to pay all or a substantial part of the redemption proceeds to the investor. In times of reduced liquidity or an unexpected surge in redemption requests, the fund may suspend the acceptance or payment of redemptions, which is often a harbinger of a formal insolvency proceeding.

Nature and Priority of Redemption Creditors

The first decision, Pearson v Primeo Fund,[1] primarily concerned the nature and priority of the claims of investors whose shares were redeemed before the suspension of payments but had yet to be paid their redemption proceeds. The dispute was between the additional liquidator of Herald Fund SPC and a representative of the redeeming shareholders, Primeo Fund. Herald invested all of its raised funds with Bernard L Madoff Investment Securities LLC. When the Madoff fraud was discovered, Herald suspended redemptions. It was later placed into court-ordered liquidation. Primeo claimed to be a creditor of Herald for the amount of redemption proceeds attributable to its redeemed shares, subordinate to ordinary creditors but ranking ahead of unredeemed shareholders. Herald’s liquidator took the position that Primeo, and other investors similarly situated, ranked only as ordinary shareholders.

The liquidator relied on section 37(7) of the Companies Law, which prescribes the circumstances for when the terms of redemption for “shares which are or are liable to be redeemed” may be enforced against a company in winding-up proceedings. The liquidator argued that “redemption” and “redeemed” in section 37 had a different meaning than under Herald’s articles of association, with the statute requiring payment to actually have been made for a redemption to be completed, and that the terms of section 37(7) effectively rendered Primeo an unredeemed shareholder because it had not been paid as of the date the liquidation commenced. Primeo’s position was that section 37(7) did not apply at all, because Primeo’s shares had been redeemed before Herald suspended the payment of redemptions and calculation of net asset value, and that as of that redemption date Primeo was owed a simple debt from Herald for the redemption proceeds.

The Privy Council, like the Grand Court and the Court of Appeal before, favoured the position of Primeo. It found no textual basis for the statutory interpretation advanced by Herald’s liquidator and referred to a previous decision in which the board underlined the general freedom for companies and their shareholders to define their relationship, including with respect to redeeming shares, however they may think appropriate.[2] Where the articles did not require receipt of payment to complete the redemption, the Companies Law did not impose any such requirement, including under section 37(7).

The board’s decision confirms that upon shares being redeemed in accordance with a company’s articles of association, the redeeming shareholder becomes a creditor (commonly called a redemption creditor) of the company for the amount of the redemption price payable. Payment before a liquidation commences or a suspension of payments is not required. Any grace period allowed for the company to make the payment does not affect the status of the redemption. While the redemption creditor’s claim is subordinate to ordinary creditors whose debts did not arise from a shareholder relationship,[3] it will rank ahead of shareholders who were not able to redeem their shares before the commencement of the liquidation.

In practical terms, it is often very favourable for an investor to convert itself into a redemption creditor. Particularly at the feeder level in a hedge fund structure, where there are few if any ordinary creditors, leapfrogging over their peers is advantageous for investors and likely to result in much greater recovery. When warning signs appear in a Cayman-incorporated hedge fund, expect to see earlier and preemptive redemption requests as investors try to win the race to the finish line to take priority over those that lag behind.

Paying Redemption Proceeds — And Trying to Claw Them Back

In the second decision, DD Growth Premium 2X Fund v RMF Market Neutral Strategies[4] the board considered a claim by the liquidators of DD Growth that certain redemption payments made to former shareholder RMF prior to the commencement of the liquidation were unlawful payments out of the capital of DD Growth under the applicable provisions of the Companies Law.[5]

Like most modern corporate law regimes, the Companies Law restricts companies from making redemption payments when the company is insolvent or would become so by making the payment. However, the restrictions in Cayman are fairly narrow. Only payments “out of capital” are subject to the statutory solvency test. The primary issue before the Privy Council was whether DD Growth’s redemption payments to RMF, funded out of the share premium account, constituted payments out of capital.

While the board found that the payments were indeed out of capital at a time when the company was insolvent and therefore unlawful, amendments made to the relevant provisions of the Companies Law in 2011 mean that the specific result on this issue will have very limited impact going forward. Those amendments narrowed even further the applicability of the statutory solvency test for redemption payments by clearly removing share premium from the definition of “out of capital.” On the current state of the law, it appears that only the company’s funds attributable to the nominal or par value of issued shares would be considered “out of capital” for these purposes. As most Cayman funds issue shares with very low par values, there will practically be very few circumstances where a payment to a redeeming shareholder will be subject to the statutory solvency test.

Even where a redemption payment is unlawfully made, whether as a payment out of capital or in breach of the directors’ fiduciary duties, the board confirmed that there is no automatic right to recover against the redeeming shareholder. Where the underlying redemption is valid, the payment to the shareholder will discharge that debt, so the doctrine of unjust enrichment will not apply. Recovery must instead be based on knowing receipt, which requires the redeeming shareholder to have had knowledge that the payment to it was unlawful so as to become a constructive trustee of the funds.[6] Such knowledge of the internal affairs of the company will likely be difficult or impossible to prove in most cases, giving further comfort to redeeming shareholders that payments made to them will not be subject to attack in a future insolvency.