A recent decision of the Privy Council dismissing the claim of liquidators of an insolvent hedge fund to claw back redemption payments made to an investor leaves lingering uncertainties for investors generally.
Claw backs post 2008 crisis
Following the onset of the world financial crisis in 2008, there has been a significant amount of litigation involving insolvent or financially constrained investment funds, frequently in the offshore jurisdictions where fund vehicles have been incorporated. As economic conditions deteriorated, investors wanted their money back quickly before further losses accrued, while those in charge of fund assets sought to buy time, for an orderly exit from positions, or simply to stave off total collapse. Investors whose redemption requests had been blocked resorted to winding up petitions to unlock their assets. Vice versa, where funds permitted redemptions or where investors had a right to redeem, fund liquidators have tried to claw back redemption payments made to investors. A long running and prominent piece of such litigation was between the liquidators of Weavering Macro Fund and Swedish bank SEB, which resulted in SEB being ordered to pay back USD8.2 million to the fund in the Cayman Islands.
Privy Council appeal
The Judicial Committee of the Privy Council, a body of senior UK judges sitting as the final court of appeal on the law of the Cayman Islands, has recently decided a significant case, at the tail end of the offshore litigation resulting from fund collapses in 2008 and 2009. DD Growth Premium 2X Fund was an open ended feeder fund incorporated in the Cayman Islands which invested its assets in a Master Fund. The investments in this structure was managed by Dynamic Decisions Capital Management, a hedge fund manager regulated by the UK's Financial Conduct Authority. The Master Fund's stated strategy was to invest primarily in correlated long/short pairs of large-cap US equities.
The Master Fund collapsed in 2009, with investors losing most of their money. Alberto Micalizzi, the founder of Dynamic Decisions Capital Management and the chief investment officer, was banned from financial services in 2012 for concealing the fund's losses from investors. Micalizzi escaped criminal prosecution, but was handed a large civil fine.
Investors in the feeder fund were issued with redeemable shares, enabling them to redeem their investment on 30 days' notice in writing. RMF, a fund of funds business and part of Man Group, was an investor in the feeder fund who sought to redeem some of its shares at a time when the feeder fund was in fact insolvent, but when its financial position was being misreported to investors as being healthy. According to evidence given by RMF to the financial services tribunal charged with reviewing the decision to ban and fine Micallizi, RMF lost confidence in Micallizi's explanations for some of the investments in the Master Fund and decided to redeem in full – but was unaware of the losses the Master Fund had suffered when it made the redemption request. Micallizi did not challenge that evidence. The feeder fund paid out about USD23 million to RMF.
When the fund went into liquidation, its liquidators sought to recover this sum. The principal issue was one of Cayman Islands' law: whether the payment was unlawful under the relevant company law statute. The courts at first instance (the Grand Court) and on first appeal held the payment to have been lawful. The matter was appealed to the Privy Council on second appeal, which held that the payment had been unlawful, on the basis that RMF's shares had been redeemed using the feeder fund's capital at a time when it was unable to pay its debts.
Unjust enrichment appeal fails
This brought into play the liquidators' claim that the feeder fund's payment had unjustly enriched RMF (on which issue, the laws of England and the Cayman Islands are materially the same). A party may be unjustly enriched if he receives funds under an agreement for which the consideration has failed. The liquidators argued that the consideration for the redemption of RMF's shares had failed, on the basis that the payment out of the feeder fund's capital had been unlawful. That claim was rejected, on the basis that (in the Privy Council's judgment) RMF's redemption request and the cancellation of its shares had been valid and lawful. The fact that the feeder fund's paying (part of) the sum owed as a result had been unlawful was irrelevant.
For investors in Cayman-domiciled funds, the Privy Council's decision to dismiss the unjust enrichment claim may be of limited comfort. The Privy Council noted the trial judge's concerns that "to subject the lawfulness of a payment of redemption premium out of share premium account to a solvency test would expose investors to unacceptable risks of uncertainty because of the risk of claw-back claims, sometimes long after redemption, arising from facts internal to the issuing company, unknown to the investor but affecting the commercial solvency of the company." The Privy Council thought that those concerns could be met by making liability to claw-back essentially dependent upon whether the investor was aware of the insolvency of the fund at the time of his redemption request. Notwithstanding the relative rarity of funds actually becoming insolvent, potential exposure to claims which depend on a difficult and fact-sensitive inquiry into the state of the investor's mind will be unattractive to investors. Solvency "due diligence" that might be needed in some circumstances to make redemptions safe from claw-back could be burdensome.
Knowledge based claw back?
The next phase of the RMF litigation will be worth watching to see whether such concerns are realised. The liquidators have permission to pursue a knowledge-based claw back case against RMF, and will now have to decide whether to challenge RMF's evidence that it knew nothing about the feeder fund's insolvency at the time of redemption. The Privy Council remitted this issue to the Grand Court of the Cayman Islands.