The Cayman Islands Court of Appeal has re-affirmed the distinction between segregated portfolio companies (“SPCs”) and their segregated portfolios and the insolvency implications for each.
In ABC Company (SPC) v J & Co. Ltd (CICA Unreported, May 2012) the Court of Appeal re-affirmed that the insolvency of one segregated portfolio in an SPC will not impact the other segregated portfolios in that SPC so as to require a winding up order to be made over the SPC as a whole. The Court of Appeal’s decision is believed to be the first reasoned judgment of the Cayman Islands courts dealing with the winding up of SPCs.
Case background
The facts in the ABC case, were that ABC Company (SPC) (the “Company”) was incorporated as an open ended investment fund. The offering memorandum dated 21 December 2010 stated that the general investment objective of the Company was to “provide investors with an opportunity to benefit from capital growth and income opportunities in the world’s equity, bond, property and currency markets”. The offering memorandum listed 82 segregated portfolios of the Company as at 21 December 2010 and indicated that a further 16 segregated portfolios were to be launched on 1 January 2011. All of the segregated portfolios were established to operate as open ended investment funds.
J & Co. Ltd (the “Petitioner”) held participating redeemable preference shares issued in respect of one of the Company’s segregated portfolios which invested exclusively in real estate in Germany (the “German Fund”).
On 26 February 2008, investors in the German Fund were advised that a decision had been taken to suspend temporarily the calculation of the Net Asset Value (“NAV”) of the German Fund. The effect was to suspend all subscriptions and redemptions of shares issued in respect of the German Fund. Between February 2008 and 24 June 2011 the NAV of the German Fund was not calculated or published; and no subscriptions or redemptions in respect of the German Fund were permitted. During the period of suspension the directors of the Company apparently continued to pay management fees to the fund manager.
On or about 12 April 2010, the directors of the Company proposed changes to the articles of association and offering memorandum. The changes were stated to be necessary as they would:
“. . . allow the Directors to instruct the Fund Administrator to calculate and publish the NAV on a monthly basis, (the NAV is the total of the Fund’s assets less the total of the Fund’s liabilities) without automatically recommencing the subscription/redemption cycle for each of the sub-Funds. This will restore full transparency on values for Shareholders and may facilitate the creation of a secondary market in the Sub-Fund’s shares. The changes would also allow the Directors to set redemption gates, allowing the orderly management of redemptions from the Fund once the suspension on redemptions is lifted.”
The proposed changes were approved by special resolutions passed at shareholder meetings (at over 60 class meetings) of each segregated portfolio.
The Petitioner through its US counsel wrote to the directors of the Company and the fund manager raising a number of issues regarding the management and status of the German Fund. In response to that letter the Fund Manager provided the Petitioner (through its US counsel) with a document described as a “Fund Update” in which it was stated (i) that the assets of the German Fund were to be liquidated over the following three years and pro-rata distributions of capital were to be made to shareholders as liquidity allowed (a process described as the “Liquidation”); (ii) that NAV calculation would recommence in February 2011, but redemptions of shares would remain suspended for the duration of the Liquidation (estimated to be until 2013); (iii) that the German Fund would continue to issue to investors half-yearly valuations and yearly audited financial statements; and (iv) that the investors would receive “quarterly notes about the progress of the Fund”.
The Petitioner brought a winding up petition against the Company on the grounds that it had lost its substratum because one third of its segregated portfolios had suspended subscriptions and redemptions, including the single segregated portfolio in which the Petitioner was invested (i.e. the German Fund) and it was therefore “just and equitable” for the Court to wind up the Company. The Petitioner pointed out that in addition to the German Fund, there were about eighteen (18) other segregated portfolios of the Company which had ceased subscriptions and redemptions and were now in suspension (together with the German Fund the “Suspended SPs”). The combined NAV of the Suspended SPs constituted approximately one-third (?) of the aggregate NAV of all the Company’s segregated portfolios. The Petitioner therefore argued that as a result of the failure of certain of its segregated portfolios, as detailed above, the Company had ceased to carry on business in accordance with the reasonable expectations of its shareholders based on the representations made in the Company’s offering memorandum and therefore the substratum of the Company had failed.
The Court of Appeal, reversing the Grand Court decision, ordered the petition to be struck out on grounds that it was bound to fail.
The key features of an SPC
SPCs are corporate vehicles created under the Companies Act in the Cayman Islands which provides for the creation of SPCs which may establish one or more segregated portfolios which segregate the assets and liabilities attributable to each segregated portfolio from the assets and liabilities attributable to each of the other segregated portfolios, and from the general assets of the company.
The Companies Act was amended in late 2001 to remove the restriction on the use of SPCs for insurance purposes only and now any exempted company may be structured as an SPC. The SPC structure has traditionally been utilized to allow for the establishment of segregated portfolios to segregate the assets relating to classes of shares with different investment criteria. This protects shareholders of different classes in one segregated portfolio from the potential of cross liability arising from the adverse investment performance of other classes of shares in other segregated portfolios. SPCs are also used in connection with multiple tranche debt issuing vehicles and special purpose vehicles used for the purpose of securitization transactions.
Although a segregated portfolio must be separately identified it is not a separate legal entity from the company. The SPC is and remains a single legal entity and a segregated portfolio does not constitute a legal entity separate from the SPC itself. Assets of the SPC are either segregated portfolio assets or general assets. The Directors of an SPC have a duty to establish and maintain procedures to ensure the segregation of each segregated portfolio’s assets from those of other segregated portfolios and from the general assets of the SPC and to ensure that assets and liabilities are not transferred between segregated portfolios otherwise than at full value. If the assets attributable to a particular segregated portfolio are insufficient to satisfy the liabilities attributable to that segregated portfolio, then unless specifically prohibited by the SPCs Articles of Association (the Articles normally include the prohibition), certain general assets of the SPC may be applied to discharge those liabilities. Shares may be issued in respect of a particular segregated portfolio the proceeds of which are included in the assets of such segregated portfolio and which may carry the right to distributions from that segregated portfolio. The SPC may create and issue shares in one or more classes or series (including different classes or series relating to the same segregated portfolio).
Under section 92 of the Companies Act, the Cayman Islands Courts have jurisdiction to appoint official liquidators over an SPC as a whole either on the ground of (i) insolvency (i.e. the SPC is unable to pay its debts as they fall due) or (ii) on just and equitable ground (i.e. the Court is of the opinion that it is just and equitable that the company should be wound up).
In respect of segregated portfolios of an SPC that are facing financial difficulties or solvency issues, shareholders and creditors can petition the Courts to appoint a receiver over the segregated portfolio in question on the basis that its assets “are or are likely to be insufficient to discharge the claims of creditors in respect of that segregated portfolio” (i.e. on the grounds of insolvency). The receiver will then be appointed in order to manage (i) the orderly closing down of the business of or attributable to the segregated portfolio; and (ii) the distribution of assets attributable to the segregated portfolio.
However, whilst a receiver can be appointed to manage the affairs of an insolvent segregated portfolio, the Companies Act does not expressly provide for the appointment of a liquidator or receiver over an individual segregated portfolio on “just and equitable” grounds relevant to the segregated portfolio. Accordingly, if a segregated portfolio has suspended redemptions but it is still solvent, the Companies Act does not expressly provide an investor with any remedy in respect of the individual segregated portfolio.
Analysis
In the ABC case, the Petitioner relied heavily on the Cayman Islands case authorities including Re Belmont Asset Based Lend Ltd [2010] 1 CILR 83 and Re Heriot African Trade Finance Fund Limited [Unreported] which in recent times have become authority for the proposition that a fund cannot be said to be carrying on business as an open-ended investment fund if its ability to redeem shareholders in cash and accept new subscriptions has been terminated. These cases have also held that a long term suspension of redemptions followed by the economic liquidation of assets by the fund manager and subsequent distributions to investors over time (i.e. a "soft wind down") is never within the reasonable expectation of investors without express language in the offering documents. These cases have also held that such a fund has ceased to be viable as an investment fund as it is not in the ordinary course of business for a fund to suspend redemptions and for the fund manager to undertake an economic liquidation of the fund’s assets. These cases have held that in these circumstances, a fund will be considered to have "lost its substratum" making it just and equitable for the Cayman Islands courts to grant a winding up order.
In the ABC case, the Company applied to strike out the Petitioner’s petition by arguing that the petition was bound to fail because (i) the relevant segregated portfolio (i.e. the German Fund) was not insolvent and the Court had no jurisdiction under the Companies Act to grant a winding up petition in respect of a segregated portfolio (as opposed to the SPC itself) on “just and equitable” grounds (ii) even if the line of reasoning adopted in cases such as Re Belmont Asset Based Lend Ltd [2010] 1 CILR 83 and Re Heriot African Trade Finance Fund Limited [Unreported] were correct, the SPC could not be said to have lost its substratum where two thirds (2/3) of its segregated portfolios were operating as normal (i.e. had not suspended subscriptions, redemptions or the calculation of their net asset value).
At the Court of Appeal hearing the Petitioner conceded that the Companies Act did not permit a single segregated portfolio to be wound up; a receiver can be appointed by the Courts but this is only available on the grounds of insolvency but not on the just and equitable ground. The Court of Appeal was therefore not required to pass judgment on this issue.
The Court of Appeal’s decision affirms, if any affirmation was needed, that the SPC structure will be respected by the Cayman Islands courts in the context of a winding up petition where the offering documents and articles of association are clear in respect of the manner in which shares in segregated portfolios may be suspended. The mere fact that certain segregated portfolios are suspended is not, of itself, sufficient to justify a winding up order being made in respect of the SPC as a whole.
The decision has implications wider than the SPC context. Even though the Court of Appeal was not required to decide on the circumstances in which a Cayman Islands investment fund might be said to have lost its substratum, the Court of Appeal did not expressly or by implication endorse the decisions in Re Belmont Asset Based Lend Ltd [2010] 1 CILR 83 and Re Heriot African Trade Finance Fund Limited [Unreported] and other similar line of case authority. The Court of Appeal contrasted those decisions with the decision of the Eastern Caribbean Supreme Court (British Virgin Islands) in Aris Multi-Strategy Lending Fund v Quantek Opportunity Fund (unreported, 15 December 2010) which disagreed with the approach taken in the Cayman Islands cases and then stated:
“It must be anticipated that an appeal will come before this Court in which it will be necessary to choose between the approach of Justice Jones in Belmont and Heriot, on the one hand, and that of Justice Bannister in Aris v Quantek on the other hand: or, perhaps, to decide that the true approach in this jurisdiction should lie somewhere between the approaches respectively adopted in those cases. But this is not that appeal.”
It is arguable that the fact that the Court of Appeal decided not to endorse the decisions in Re Belmont Asset Based Lend Ltd [2010] 1 CILR 83 and Re Heriot African Trade Finance Fund Limited [Unreported] and other similar line of case authority, will encourage investment funds seeking to challenge winding up petitions brought by activist or disgruntled investors on the grounds of loss of substratum due to a suspension of subscriptions and redemptions.
In this case, the company’s offering memorandum had been amended and approved by the company’s shareholders to give the company’s directors the power exercisable “in their absolute discretion and for any reason” to declare a suspension (i.e. to suspend the calculation of NAV, and/or the issue of shares, and/or the redemption of shares, and/or the payment of redemption proceeds). The shareholders in each class of the segregated portfolios had voted on, at class meetings, and approved the inclusion of the above stated power in the company’s articles of association. The Court of Appeal was therefore of the view that, bearing in mind the approval process that was undertaken by the company to amend the company’s offering memorandum and its articles of association:
“it is impossible for the petitioner to contend that a bona fide exercise by the directors of the power (conferred by Article 59 of the amended Articles) to declare a suspension in relation to the German Fund – and other Real Estate Funds - was outside the reasonable expectations of the holders of segregated portfolio shares issued in respect of that fund or those funds; or outside the reasonable expectations of shareholders generally. Rather, it must be accepted that, when voting on the resolutions to amend the Articles of Association in 2010, shareholders appreciated, and intended, that the directors (acting bona fide) should be able to exercise that power if, in their discretion, they determined that the interests of the Company so required.”
The Court of Appeal also pointed out that the company’s offering memorandum also contained risk warnings such as:
“The liquidity of some of the investments held by the Segregated Portfolios cannot be guaranteed. Any illiquidity may prevent a Segregated Portfolio from concluding an investment transaction on satisfactory terms and, in certain circumstances, may prevent redemptions of (and subscriptions for) investments and Shares.”
Accordingly, the Court of Appeal was of the view that it would be obvious to experienced investors (to whom offering documents are addressed) contemplating investment in an open-ended investment funds that the ability of the investment fund to redeem the investor’s investment in a segregated portfolio from time to time would depend on the liquidity of that segregated portfolio. The Court of Appeal stated that, illiquidity – whether a consequence of inability to realise investments (or an inability to do so save on the basis of a “forced sale” price) in a depressed market or of a lack of new investors – is likely to lead to an inability to “pay out” those who wish to redeem. An appreciation that that is a feature of an open-ended investment fund must, stated the Court, be part of the reasonable expectations of those who chose to invest in such funds.
Chris Humphries