In an unprecedented turn of events, two recent proceedings in the Grand Court of the Cayman Islands considered the same complex legal issues just one week apart. Both In the Matter of HQP Corporation Limited[1] (assigned to Justice Doyle) and In the Matter of Direct Lending[2] (assigned to Justice Segal) considered: (i) whether a shareholder who had been induced by a fraudulent misrepresentation to subscribe for shares in a company could claim damages against that company in its liquidation; and (ii) if so, how would such claims rank in the liquidation of the company?
The HQP decision is presently subject to an appeal initiated by certain shareholders of HQP Corporation Limited (in Official Liquidation) (the "HQP"). It is uncertain at this time whether there will be a substantive appeal of the Direct Lending decision.
Tom Smith KC of South Square Chambers, together with Shelley White, Siobhan Sheridan and Charlotte Raynor of Walkers' Cayman Islands IDR Group are advising the joint official liquidators of HQP, Christopher Smith and Martin Trott of R&H Restructuring (Cayman) Ltd.
Background
In these otherwise completely unrelated cases, investors in Direct Lending[3] and HQP subscribed for shares in the companies. In both cases the value of the companies had been misleadingly inflated, and financial records of HQP had also been falsified. Investors in HQP allege that those misrepresentations induced them not only to subscribe for the shares but also to accede to the creation of later series of shares and to consent to those shares having priority over the earlier ones by amendments to the Articles of Association.
In the circumstances, the liquidators of both companies were faced with an important question: can shareholders who were induced by fraudulent misrepresentations to buy shares in a company bring damages claims for misrepresentation in that company's liquidation? Although it had never been considered in the Cayman Islands, the English House of Lords decision in Houldsworth,[4] which dates back to 1880, precluded such claims.[5] A second question therefore arose: is Houldsworth good law in the Cayman Islands?
Despite the fact that Direct Lending was wound up nearly 3 years earlier than HQP,[6] the JOLs' summons in HQP came on for hearing on 17-18 May 2023 with Direct Lending following the next week on 25-26 May 2023. Justice Doyle handed down his judgment in HQP on 7 July 2023 and made the following findings:
- Houldsworth is not good law in the Cayman Islands, meaning shareholders may in principle issue claims for misrepresentation against insolvent companies.
- The facts of HQP are not distinguishable from that of Houldsworth.[7]
- Irrespective of whether Houldsworth applies, such fraudulent misrepresentation claims[8] by shareholders are not brought "in their character of a member", and therefore fall outside of section 49(g) Companies Act (2023 Revision), the "Companies Act".
- Therefore, claims for misrepresentation by preferred shareholders should rank as ordinary non-shareholder, creditor claims.
Justice Segal did not hand down his judgment in Direct Lending until 13 March 2024 and therefore had the benefit of Justice Doyle's decision in HQP. Justice Segal's judgment did not follow that of Justice Doyle, instead finding:
- Houldsworth remains good law in the Cayman Islands - it would be for the Cayman legislature to modify or abolish this common law rule.
- The facts of Direct Lending are distinguishable from the facts in Houldsworth.
- A qualified formulation of the rule in Houldsworth applies, meaning the ability of a shareholder to seek damages for misrepresentation against an insolvent company is limited but not barred entirely.
- Misrepresentation claims are claims of shareholders / members and any damages received are "by way of dividends, profits or otherwise" within section 49(g) Companies Act.
- Therefore, claims for misrepresentation by preferred shareholders are provable once non-shareholder creditors have been paid in full, and those claims rank pari passu inter se, together with any redemption creditors.
Key Observations
As it stands, the uncertainty regarding shareholder misrepresentation claims in liquidations following the decisions in HQP and Direct Lending remains to be resolved. Official liquidators do not yet have clarity as to the approach required to be adopted by them in determining such claims and giving effect to the statutory waterfall; and similarly, shareholders do not have certainty as to the treatment of their claims (and resulting recoveries) in a liquidation. Authoritative guidance is required from the Cayman Islands Court of Appeal, and – given the importance of this issue and the matters at stake – perhaps also from the Judicial Committee of the Privy Council.
Further, even once that guidance is available, the adjudication and valuation of such claims will be far from straightforward.
The HQP and Direct Lending cases also raise interesting considerations relating to the correct approach to the costs incurred in connection with such proceedings, both at first instance and on appeal. There is a good argument that when there is a genuinely complex and difficult point of law that results in liquidators requiring the guidance of the Court, then the costs of the parties advancing those arguments should come out of the estate. After all, the application is being brought for the benefit of all stakeholders. Does that position pertain on an appeal? Are the prospects of success of that appeal relevant? What if the original point of contention is raised by a small minority of shareholders advancing a self-serving but speculative case with a view to improving their ultimate recovery? The court has a very wide discretion when it comes to costs, and whilst in cases like Direct Lending and HQP it may seem obvious that the costs – at least at first instance – should be paid from the liquidation estate, that will not necessarily be the same on every set of facts.
HQP was listed for appeal on 1-2 May 2024. The handing down of the judgment in Direct Lending just 6 weeks earlier, when the Appellants' Skeleton had already been served in HQP, presented something of a spanner in the works of that proceeding. The Cayman Islands Court of Appeal was sufficiently concerned that there might be an overlapping appeal in Direct Lending, that it adjourned HQP of its own motion. Further, the Justices of Appeal gave what they described as the "strongest indication" that the Direct Lending order should be sealed within 7 days so that time would start running for the filing of any appeal, and that any appeal in that matter should be heard along with the appeal in HQP.
In the meantime, therefore, we must watch and wait. Walkers will prepare a substantive update in due course following the appeal hearing.
[1] (in Official Liquidation) FSD 190 of 2021 (DDJ) (7 July 2023).
[2] (in Official Liquidation) FSD 108 of 2019 (NSJ) (13 March 2024).
[3] Specifically, Direct Lending Income Feeder Fund, Ltd (in Official Liquidation); together with Direct Lending Income Fund, L.P, the feeder funds to DLI Capital Inc, the master fund.
[4] Houldsworth v City of Glasgow Bank (1880) 5 App. Cas. 317 (H.L. (Sc.)).
[5] The House of Lords unanimously held that a shareholder who has been the victim of fraud or misrepresentation in subscribing for shares is limited to renouncing their shareholding and claiming in restitution and, in any event, renouncing shareholding by way of recission is not possible once a company enters liquidation.
[6] Direct Lending entered into official liquidation on 25 July 2019, whereas HQP entered official liquidation on 5 April 2022.
[7] Mr Houldsworth purchased £4,000 shares in the City of Glasgow Bank (a co-partnership registered under the Companies Act 1862) having been induced by fraudulent misrepresentations by the company's directors as to the solvency of the bank. Upon the collapse of the bank, Mr Houldsworth issued a claim against the bank and its liquidator, seeking damages for monies paid for stock and towards the bank's debts, as well as for future payments that he could be called upon to pay.
[8] i.e. pre-contractual torts in deceit.
[View source.]
