From Mourant Ozannes

RMF Market Neutral Strategies (Master) Limited v DD Growth

Premium 2X Fund (in official liquidation)

A recent case of the Grand Court of the Cayman Islands held that payments made by insolvent companies out of share premium to redeemed shareholders cannot be clawed back by a liquidator using section 37(6) of the Companies Law.

In adopting this narrow definition of ‘capital’, this decision means that section 37(6) is unlikely to impact upon the majority of Cayman funds, which normally issue shares with very low nominal capital.

Background

DD Growth Premium 2X Fund (the 2X Fund) was one of two feeder funds in a “master- feeder” structure. It shared common directors with DD Growth Premium Master Fund (the Master Fund), including one director (Alberto Micalizzi) who was also a director of its Investment Manager.

The 2X Fund had initially sold its shares to subscribers for US$100 or €100 per share. However, the par value of those shares was only US$0.001 or €0.001 per share. Therefore, the nominal capital of the 2X Fund (which would have been US$10 and €10 if the 2X Fund has issued 10,000 of each class of shares on day one) was minimal compared to the value of its share premiums (which would have

been US$999,990 and €999,990). It is not at all unusual for Cayman funds to be structured in this manner.

In early 2009, it became clear that Mr Micalizzi had caused the Master Fund’s assets to be overstated, and that only around US$30m of assets remained, rather than the previously- reported US$500m. Subsequently, investors took steps to wind up the DD Funds and all three of them went into liquidation in 2009.

Payments to Redeeming Shareholders

In late 2008 and early 2009, before the overstatement had been detected by the rest of the board, Mr Micalizzi had caused the 2X Fund to continue to accept redemption requests and make redemption payments to some of its investors. RMF Market Neutral Strategies (Master) Limited (RMF) was one such investor. It had submitted redemption requests for the 1 December 2008 redemption date, giving rise to rise to a liability (calculated using the overstated NAV) of more than US$62 million, which the 2X Fund was obliged to pay by 19 December 2008. In addition to RMF, there were six other December redeemers, who together were owed US$17m.

However, the 2X Fund was unable to make the required payments to all of the December redeemers. This is because, as the Court held, it was both cash-flow and balance- sheet insolvent at the relevant times, which were when the payments were made. Notwithstanding its insolvency, the 2X Fund exhausted its remaining cash on-hand by (i) paying three December redeemers in full, and (ii) making a series of part-payments to RMF in January and February 2008, amounting to around US$22m of the US$62 owed. The 2X Fund made no payments to the three other December redeemers.

The Court held that Mr Micalizzi had been concerned that, absent the payments, RMF would take legal action against the 2X Fund. It noted that the evidence revealed a picture of unrelenting and escalating pressure being applied by RMF (which included two separate unannounced visits to the Investment Managers’ London and Milan offices) and that, in making the payments to RMF, Mr. Micalizzi was responding to [this] pressure.

Grand Court Proceedings

The question arose as to whether, in the circumstances, the 2X Fund and its liquidators had valid claims to claw-back the US$22m paid to RMF.

The 2X Fund’s principal arguments were that1:

1. The payments were rendered unlawful by s.37(6)(a)2 of the Companies Law (2007 Revision), because they were payments out of capital and the 2X Fund was cash-flow insolvent at the relevant dates. This gave rise to restitution and/or constructive trust claims against RMF.
2. The payments were paid pursuant to mistakes of fact or law as to the solvency of the 2X Fund, so as to give rise to a restitution claim allowing the 2X Fund to claw-back the sums paid to RMF.
3. The payments were fraudulent preferences, under s.168 of the Companies Law (2007 Revision).

Decision

Section 37(6)(a)

The key question considered by the Court was whether or not the payments made by the 2X Fund (which it was clear had largely, if not entirely, been made out of share premium) fell to be treated as payments out of capital for the purposes of s.37(6)(a).

The 2X Fund had argued that ss.37(5)(a) and (b) of the Companies Law (2007 Revision), taken together, meant that all payments otherwise than out of a company’s profits or the proceeds of a fresh issue of shares were to be regarded as payments out of capital for the purposes of s.37(6)(a)3.

The Court rejected this argument, describing it as a strained and tortuous construction. In reaching this conclusion, the Court appears to have been influenced by two factors:

First the Court highlighted the fact that the Companies (Amendment) Law 2011 added the words “share premium account” to the relevant parts of s.37(5)(a)4. It noted that Hansard described these amendments as

clarifying (rather than substantively amending) the Companies Law. Accordingly, given that there was no argument that the payments would have been unlawful returns of capital after the 2011 Amendment Law, the Court held that they were also not rendered unlawful by s.37(6) before that amendment.

Second, the Court appeared to be influenced by its views on the ordinary workings of Cayman funds, which commonly permit redemptions on a first come first served basis. The Court noted that normally investors in Cayman funds can expect to be able to redeem their shares, at the prevailing NAV per share of the Fund, with very little exposure to risk of liability to third party creditors whose interests would out-rank investors’ in the event of insolvency. In this manner, the Court appeared to have regard to the interests of such redeeming investors, and the need to provide them with certainty that they would not be subject to later claw-back claims in relation to such payments.

Having found that the relevant payments fell outside the provision of s.37(6), the Court concluded that this determined all of the 2X Fund’s claims other than the fraudulent preference claim. It then went on to consider that claim, finding that in causing these payments to be made, Mr Micalizzi had merely been responding to the pressure exerted on him by RMF, and that his dominant intention had not been to prefer RMF over the 2X Fund’s other creditors.

The 2X Fund also had also pleaded a knowing receipt claim, but because of the unusual nature of the way the case had progressed, this had been held over to a later hearing, if necessary.

2 Section 37(6)(a) provides: 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.

3 Section 37(5) provides:

1. Subject to this section, a company limited by shares or limited by guarantee and having a share capital may, if so authorised by its articles of association, make a payment in respect of the redemption or purchase of its own shares otherwise than

out of its profits, share premium account, or the proceeds of a fresh issue of shares.

1. References in subjection, (6) to (9) to payment out of capital are subject to paragraph (f), references to any payment so made, whether or not it would be regarded apart from this subsection as a payment out of capital

The highlighted words were added by the Companies (Amendment) Law 2011

4 And other related sections of the Law.

Analysis

Preference

The part of the Companies Law dealing with preferences was amended on 1 March 2009. At present, s.145 governs voidable preference claims. However, the relevant test of intention, namely whether or not the payment was made with a view to giving such creditor a preference over the other creditors remains the same as that under the old s.168. As such, this decision serves as a timely reminder of the nature of the ‘intention’ test and confirms that a company responding to commercial pressure will normally lack a dominant intention to prefer one creditor above another.

Capital Maintenance Rule

The treatment of s.37(6) is likely to be of more controversy and wider interest, given that this is the first Cayman judgment considering the application of this section. In reaching its decision, the Court appears to have effectively confined s.37(6) to a very narrow category of cases. S.37(6) will only apply to render repayments of the nominal value of issued shares unlawful. In most cases, the amounts of such capital will be minimal and it will not make economic sense for liquidators to bring claims for the repayment of these sums.

The analysis underpinning this decision is also interesting because the Court expressly considered the effect of s.34(2) of the Companies Law5, which prior to the 2011 Amendment Law, dealt with payments out of share premium on redemption of shares. S.34(2) imposes a similar solvency requirement to s.36(7), in respect of all payments out of share capital for distributions and dividends to shareholders. The Court appears to have concluded that the payments in question were not distributions and therefore did not have to satisfy this solvency test (which they would have failed to do, given the 2X Fund’s insolvency). However, the Court did not directly explain its reasoning for this conclusion which, in the circumstances, appears slightly surprising.

Application of solvency test

Whilst it may only be of marginal relevance in the future, the Court also appears to have resolved one of the longstanding questions about s.37(6), namely whether a fund’s debts for the purposes of the section 37(6) test will only include debts to third party creditors, or also include liabilities owed to redeeming shareholders. Although not mentioned explicitly, it appears implicit from the Court’s finding that the 2X Fund was insolvent that redemption liabilities fall to be considered in this context.

Practical Considerations

Following on from the Privy Council decision in the BVI Case of Fairfield Sentry, this judgment marks another set back for attempted claw-back claims by liquidators against redeemed investors. As such, it will provide some additional comfort to those who received payments from insolvent funds in the past.

As matters stand, s.37(6) will not provide the liquidators of insolvent funds with claw-back claims against such investors. This is likely to disadvantage everyone other than the investor who successfully receives his payment ahead of the pack. As noted by the Court, in this case those victims included the three unpaid redeemed investors and all of the unredeemed investors.

The Court also expressed the view that it was regrettable that Mr Micalizzi had, in essence, put into effect, a fraudulent Ponzi Scheme.

5 Section 34(2) provides:

The share premium account may be applied by the company subject to the provisions, if any, of its memorandum or articles of association in such manner as the company may, from time to time, determine including, but without limitation –

1. paying distributions or dividends to members;

…

1. in the Any manner provided in section 37;

…

1. providing for the premium payable on redemption or purchase of any shares or debentures of the company; Provided that no distribution or dividend may be paid to members out of the share premium account unless, immediately

following the date on which the distribution of dividend is proposed to be paid, the company shall be able to pay its debts as they fall due in the ordinary course of business…

The highlighted words were removed [bold] and added [bold capital] by the Companies (Amendment) Law 2011.

It went on to say that Mr Micalizzi should certainly have suspended NAV calculations… and disclosed the true state of hopeless insolvency. Given these findings, whilst Mr Micalizzi may not have breached the capital maintenance provisions of the Companies Law, it is arguable that he still breached his fiduciary duties, as a director of the fund. Given the fund’s insolvency, these duties

would also have extended to the consideration of creditors’ interests, included the interests of the three unpaid redeeming investors.

Notwithstanding the dismissal of the liquidators’ claims in this case, there does not appear to be any reason why, in similar cases in the future, claims could not be brought against directors for breaches of fiduciary duty in making such payments. It may also be possible to bring claw-back claims against the recipients of such payments, on the basis that they were made by the directors in breach of their fiduciary duties. However, the precise nature of those claims and the extent to which it might be necessary to prove that the recipients knew about the directors’ breaches at the relevant times are all questions to be resolved in subsequent cases.

Mourant Ozannes has the largest litigation department in the Cayman Islands, and routinely advises liquidators and investors on claw-back claims, as well as all other aspects of insolvency and litigation. Please contact your usual Mourant Ozannes contact if you have any questions in relation to any of the issues raised in this article.

Contacts:

Simon Dickson, Partner, Cayman Islands

+1 345 814 9110 [email protected]

Christopher Harlowe, Partner, Cayman Islands

+1 345 814 9232 [email protected]

Nicholas Fox, Managing Associate, Cayman Islands

+1 345 814 9268 [email protected]

The original document can be downloaded at: http://www.mourantozannes.com/media/991143/cayman-court-clarifies-the-law-on-claw-back-claims.pdf

NOVEMBER 2014

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This briefing is only intended to give a summary and general overview of the subject matter. It is not intended to be comprehensive and does not constitute, and should not be taken to be, legal advice. If you would like legal advice or further information on any issue raised by this briefing, please contact one of your usual Mourant Ozannes contacts.

Contacts:

Simon Dickson

Partner, Cayman Islands

Christopher Harlowe

Partner, Cayman Islands

Nicholas Fox Managing Associate, Cayman Islands

END

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