[author: Heather Neilson]
In the recent case of Re FIA Leveraged Fund the Grand Court considered whether an in specie distribution properly discharged the Fund’s liability to redeeming investors.
Rather like the recent Weavering decision, the factual matrix involved was at an extreme end of the spectrum; also like that case the decision of the Grand Court does not recast the law but provides a useful clarification of it. The principal points which emerge provide useful guidance to draftsmen of funds’ constitutional documents, and for investment managers contemplating in specie distributions. In short, the Court opined that wide (or very wide) discretions granted to directors (i) should be properly exercised so that proper and due care should be applied to the choice of assets to be distributed, in particular in relation to their value, and (ii) should be construed so as to give commercial efficacy to the agreement between fund and investor – no commercial efficacy would be provided by a discretion purportedly cast so widely as to allow a fund to meet a valuable redemption debt, through the payment of a worthless or near worthless asset.
The Fund and the in specie distribution
The Petitioners, three US pension funds (the Firefighters’ Retirement System, the New Orleans Fire Fighters’ Pension and Relief Fund and the Municipal Employees’ Retirement System of Louisiana) had invested USD$100m in FIA Leveraged Fund, a Cayman-registered feeder fund (the “Fund”) in a “master fund” fund structure. The master fund was Fletcher International Limited, a company incorporated in Bermuda (the “Master Fund”).
In 2011 the Petitioners sought to redeem their shares. The Fund firstly attempted to satisfy the redemption requests by issuing the Petitioners with an assignment of promissory notes that had been issued in favour of the Fund by the Master Fund. That was rejected by the Petitioners.
The Fund then purported to make a second payment in kind, which was essentially an option which had been acquired by the Master Fund to invest $65m in stock in United Commodity Banks Inc. (“UCBI”), a publically traded company on the NASDAQ (the “Option”). The deadline for the exercise of the option was May 2012. The implication was that unless the Petitioners were willing and able to invest USD$65m by that date, the Option would fall away and be of no value. Furthermore, if they failed to exercise the Option, there would be a penalty payable of US$3.25m. A further complication was a dispute between UCBI and the Master Fund surrounding the exercise of a reverse stock-split and its attendant consequences (which was the subject of litigation in New York).
The Fund’s Confidential Offering Memorandum (“COM”) provided that “if any redemption amount is paid in assets of the Fund other than cash, the value of the assets so paid shall be determined by the Board of Directors in consultation with the Investment Manager in its sole discretion.”
The Petitioners’ position
The Petitioners argued that their collective investments were worth some USD144m, but that the in specie distributions were near worthless. They maintained that the directors had cherry-picked assets which they sought to foist upon the Petitioners. For that reason the Petitioners sought to wind up the Fund on the grounds that it was unable to pay its debts or alternatively, that it was just and equitable to do so.
Complaints were also made by the Petitioners that the Fund had failed to provide any NAV calculations and/or audited valuations in respect of the redemption requests and that the Fund had failed to provide or file audited accounts since 2008.
The Fund’s position
The Fund argued that the Option was worth some USD$136m as at the date of the payment in kind which was said to be in accordance with a report of an external valuation expert firm, Quantal.
The Fund opposed the petition on the basis that it had discharged the liabilities created by the notices of redemption by making valid and effective in specie distributions to each of the Petitioners, which they were not entitled to reject. The Fund also argued that there was a genuine dispute over the debt which should not be resolved in the context of a winding up petition. It also pointed to the provisions of the Fund’s articles which it said did not permit the Petitioners to insist upon a right of acceptance prior to distribution of the nature or value of any assets proposed to be used for distribution.
There was no dispute that the Petitioners were entitled to and had effectively exercised their rights to redeem their shares in the Fund. The key issue was whether the Fund had effectively redeemed those shares and satisfied its liabilities to the Petitioners by the in specie payment.
The Court took great care to analyse the nature of the Option and its value and took into account a number of variables and uncertainties surrounding the Option such as the effect of the reverse stock-split. The Court seemed particularly interested in a second valuation carried out by Quantal on the basis of an alternative scenario in which the Option was valued at some USD$42m, as well as a value ascribed by UCBI itself in its filed accounts of USD$22.2m which tracked the value of the reverse stock-split.
The Court concluded that the Option could in no real sense be regarded as being worth anything resembling the very substantial debt due to the Petitioner and that the asset chosen for distribution was commercially worthless when compared to the value of the debt it purported to redeem.
The Court also had to consider whether there was a ‘genuine dispute’ about whether the debt had been discharged by the in specie distribution – if so, then that dispute would not be one suitable for a resolution by winding up the Fund, rather by way of trial, although the Court retains a discretion to wind up a company even where there does appear to be a genuine dispute. The Chief Justice concluded that there could be no genuine dispute about whether the Fund owes a very substantial debt to the Petitioners which had not been satisfied.
The Court confirmed that the relevant test for deciding whether a company could pay its debts as they fall due is the “cash flow” test – i.e. the present ability of the company to pay the debt when due. It queried why redemptions had not been suspended by the Fund’s managers.
As well as reviewing whether the Directors had properly exercised their discretion in selecting the Option for the in specie distribution (by reference to the value of that particular asset), it also considered what meaning was to be given to the words used in the COM as a matter of construction. The Court reiterated that the contractual terms must be construed in a way that gave them commercial efficacy (i.e. that the words used must ultimately be understood to bear the meaning which they would convey to a reasonable person against the relevant background of the transaction entered into). The Court concluded that when approaching that question of construction it would not be reasonable to conclude that the directors had an exclusive and absolute discretion to distribute in specie assets which could not be realistically be expected to give commercial efficacy to the contractual obligations owed to the Petitioners. The Court emphasised that the directors owed their shareholders and investors a fiduciary duty of care to act in good faith and the terms of corporate contracts would not be construed as having impliedly swept that duty aside.
The Court therefore granted the Petition to wind up the Fund on the basis that it was not able to pay the debt due to the Petitioners. It is interesting to note that whilst it was not necessary for the Court to do so, it also decided on the second ground of the Petition that it was in any event just and equitable for the Fund to be wound up. The Chief Justice was of the view that the company was very doubtfully solvent and therefore it was no longer possible for the company’s purpose – to maximise shareholders’ investments – to be achieved and thus its substratum had failed.
Whilst this is a case which is very fact-specific, the judgment is useful in that it underlines: (a) when the Court will consider there to be a genuine disputed debt, (b) the duty of care directors owe investors when making distributions (notwithstanding the contractual provisions of a fund’s constitutional documents) and (c) the detailed analysis the Court is prepared to undertake when deciding whether an in specie distribution is valid.
In addition, it is interesting to note that that the Court is prepared to take a purposive approach to the construction of a fund’s articles in order to give commercial efficacy to contractual provisions, even where they are widely drafted to give directors broad discretionary powers, rather than simply looking at the plain words used and taking a more strict approach to construction. It is perhaps to be welcomed that the Court appears to be willing to do what is right and fair between funds and investors.
The winding up order has been appealed; what may be of more interest than the outcome of the appeal is whether the Cayman Islands Court of Appeal will take the opportunity to make some more fundamental observations about the ability to redeem in specie.
For more information on the above, please contact Heather Neilson at email@example.com or David Herbert at firstname.lastname@example.org.