In The Courts: Fund Disputes

News Alert January 2018 In The Courts: Fund Disputes 2017 brought some key cases to the offshore courts in respect of fund disputes, focusing on issues that arose as a consequence of the global financial crisis, but had not yet been fully determined. These cases, including two decisions at Privy Council level, are useful indicators for investors of how the courts will interpret provisions dealing with redemptions and other payments made by funds in certain circumstances and determine claims brought by liquidators of funds to maximise returns following periods of financial difficulty. Unpaid investors The Privy Council s decision in Pearson v. Primeo Fund [2017] UKPC 19 confirmed that redeemed but unpaid fund investors are to be treated as creditors in a liquidation. The redeemed investors claims rank ahead of the claims of unredeemed investors. While this appeal was from the Cayman Islands Court of Appeal, it will influence all of the offshore jurisdictions. The case involved Primeo Fund (in official liquidation), an indirect investor in Bernard L Madoff Investment Securities LLC (BLMIS), through its investment in Herald Fund SPC (in official liquidation). Primeo and a number of other Herald investors submitted redemption requests for a redemption date of 1 December 2008. It was common ground that the shares had been redeemed, pursuant to Herald's articles of association on that date. Following exposure of the Madoff Ponzi scheme, Herald suspended its net asset value on 12 December 2008 and, subsequently, the payment of redemption proceeds. Herald was later placed into liquidation. The main issue in the case revolved around s.37(7) of the Companies Law (2016 Revision) which provides that the redemption of shares to be (or liable to be) redeemed but which have not been redeemed before the commencement of a liquidation, may only be enforced if (a) the terms of the redemption provided for it to take place at a date earlier than the commencement of the winding up and (b) the company could have lawfully distributed the redemption proceeds prior to the commencement of its liquidation. The key issue was whether the redemptions fell within the ambit of s.37(7), or whether, as contended by Primeo, s.37(7) did not apply to the shares, such that Primeo was simply entitled to prove as a creditor for its unpaid redemption proceeds. At first instance, the Grand Court, finding for Primeo, held that s.37(7) did not apply to the shares. The Court held that s.37(7) only applied to shares which had not been redeemed pursuant to a company's articles of association. In this instance, the shares therefore fell outside the ambit of s.37(7). On appeal, the Court of Appeal upheld the Grand Court's ruling. A redeemed investor's claim for redemption proceeds was a claim falling within s.139(1) of the Law. The Cayman Islands Court of Appeal also held that a claim for unpaid redemption proceeds falls within s.49(g) of the Law, such that those claims are paid in priority to the claims of unredeemed investors, but rank behind the claims of ordinary, unsecured creditors. Herald appealed the Cayman Islands Court of Appeal's decision. Two other classes of redeemers intervened: investors who submitted redemption requests in December 2008 prior to the suspension of the NAV and investors who submitted redemption requests after the suspension of the NAV. The Privy Council unanimously dismissed Herald's appeal. It held that the redeemers who had submitted redemption requests prior to the suspension of the NAV fell outside the scope of s.37(7). The Privy Council

found that payment is not an inherent element of the redemption... the essence of redemption is the surrender of the status of shareholder, with all attendant rights. S.37(7) does not have the effect of converting a redeemed investor from a creditor back to an investor. It confirmed the ruling of the Cayman Islands Court of Appeal that the claims of Primeo and other redeemers prior to the suspension of the NAV were subordinate to ordinary unsecured creditors but ranked above other shareholders. Clawback claims The Privy Council also determined an appeal from the Cayman Islands Court of Appeal in respect of clawback claims brought by liquidators of a Cayman fund in the case of DD Growth Premium 2X Fund (In Official Liquidation) v. RMF Market Neutral Strategies (Master) Limited [2017] UKPC 36. To read Appleby s analysis of this case click here. The case is important because the Privy Council declared that redemption payments made at a time when a Cayman Islands investment fund was unable to pay its debts as they fell due were unlawful pursuant to s.37(6)(a) of the Companies Law (2007 Revision), the version of the Law in force at the time of the payments, and remitted the matter to the Grand Court to determine whether the recipient investor is accountable for those payments as a constructive trustee. That section provides that A payment out of capital by a company for the redemption or purchase of its own shares is not lawful unless immediately following the date on which the payment out of capital is proposed to be made the company shall be able to pay its debts as they fall due in the ordinary course of business. In its majority decision, the Privy Council held (1) that s.37(5) of the Law provides a deeming definition of capital for the purpose of s.37(6), being any payment that was not out of (a) profit; or (b) the proceeds of a fresh issue of shares; (2) that, as the payment to RMF was made out of share premium, it was not out of profit or the proceeds of a fresh issue and was therefore a payment out of capital for the purpose of s.37(6); (3) that debts due to redeemed investors were debts that had to be taken into account for the purpose of s.37(6) and therefore DD2X was unable to pay its debts as they fell due at the time of each payment; and (4) that the payments to RMF were unlawful and, as that made the payments in breach of the directors fiduciary duties, the matter should be remitted to the Grand Court to determine whether RMF was accountable as a constructive trustee and required to repay the redemption payments. Duties of sub-custodian Also in 2017, Primeo Fund (in Official Liquidation) v. Bank of Bermuda (Cayman) Limited and HSBC Securities Services (Luxembourg) SA (23 August 2017) considered for the first time the duties that are owed to a fund by a custodian who then appoints a sub-custodian to manage a fund s investment. As explained in connection with the first case in this report, Primeo, a Cayman Islands investment fund, invested in the Madoff vehicle BLMIS. Until 1 May 2007 it had invested directly and from that date had indirectly invested in BLMIS through two other Cayman feeder funds, Herald Fund SPC (In Official Liquidation) and Alpha Prime Fund Limited. The Grand Court of the Cayman Islands held that the defendants breached various duties to Primeo in respect of the appointment and supervision of BLMIS as its sub-custodian. Primeo had alleged gross negligence in connection with the defendants contractual duties as custodian and administrator causing losses of USD 2 billion. The Court ruled that HSBC Securities Services (Luxembourg) SA (HSSL) had breached its duties to supervise BLMIS as sub-custodian to Primeo. Further, HSSL owed duties to ensure on an ongoing basis that BLMIS was suitable as sub-custodian. Contractually, HSSL was bound to exercise the care and skill expected of a reasonably competent global custodian. The appointment of BLMIS did not change HSSL's duties to supervise. The Court noted that BLMIS' business model included above average risks and HSSL had failed to recommend that various systems which would have allowed effective management and identification of Primeo's assets. The Court concluded that "when the normal procedure is known to be ineffective, failing to apply a readily available alternative is negligent". 2

However, despite the findings of liability, Primeo's claim was dismissed on other grounds including limitation and reflective loss. Irrespective of the ultimate result, the case is now the leading authority of the law surrounding the duties of custodians and administrators in the Cayman Islands. Winding up of a fund on public interest grounds The winding-up of offshore funds for insolvency or on just and equitable grounds following applications by aggrieved stakeholders is fairly commonplace in the offshore world. However, winding-up on public interest grounds is less common. The High Court of the Isle of Man took the step of winding up a fund on public interest grounds in Isle of Man Financial Services Authority v. The Eco Resources Fund PCC Plc (16 March 2017). The Eco Resources Fund Plc was a Qualifying Fund under the Collective Investment Scheme (Qualifying Fund) Regulations 2010. The Fund had no directors or officers and the shareholder had been placed into voluntary liquidation. In addition, the Fund was in breach of numerous provisions of the Fund Regulations such as the requirement to have audited accounts. The Isle of Man Financial Services Authority submitted that it should be wound up under s.162(6) and s.164(1)(d) of the Companies Act 1931 on just and equitable grounds and because winding up was in the public s interest. The High Court granted the order to wind up the Fund as it accepted that it was in the public interest to do so. This case is significant as it further highlights that Isle of Man financial institutions accepting investments should adhere to recognised standards and that the courts will ensure that investors have an appropriate degree of assurance in relation to their investments. Appleby acted for the liquidators in the DD Growth Premium 2X Fund (in Official Liquidation) matter and one of the interveners in the Pearson v. Primeo Privy Council appeal. 3

Key Contacts Andrew Bolton Cayman Islands +1 345 814 2011 abolton@applebyglobal.com John Wasty Bermuda +1 441 298 3206 jwasty@applebyglobal.com Andrew Willins BVI +31 657 092287 awillins@applebyglobal.com Peter McMaster QC Cayman +1 345 814 2795 pmcmaster@applebyglobal.com Anthony Williams Guernsey +44 1481 755 622 awilliams@applebyglobal.com Eliot Simpson Hong Kong +852 2905 5765 esimpson@applebyglobal.com Mark Holligon Isle of Man +44 1624 647 691 mholligon@applebyglobal.com Fraser Robertson Jersey +44 1534 818 032 frobertson@applebyglobal.com Yahia Nazroo Counsel Mauritius +230 203 4313 ynazroo@applebyglobal.com 4

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