Background

On 18 February 2013, the Cayman Islands Court of Appeal (the Court) released its judgment in Re FIA Leveraged Fund (the Fund). Mourant Ozannes acts for the liquidators of the Fund.

The decision analyses whether the Fund’s directors were entitled to make an in specie redemption by the transfer of assets acquired by the Fund after the redemption payment date and in circumstances where, on an objective basis, there were doubts as to the value of the assets. The case demonstrates that the courts will look very carefully at the actions taken by a fund’s directors and the powers available to them when considering these issues.

The judgment confirms, not surprisingly, that a fund’s power to make in specie distributions turns on a proper construction of its articles of association and offering documentation.

Decision

In FIA, the Court held that, on a proper construction of the Fund’s documentation, a payment in kind or in specie is a payment by way of a distribution from the Fund’s portfolio. The Fund’s portfolio comprised its shares in an intermediate master fund (as the Fund was a feeder vehicle in a master-feeder structure) but did not include the portfolio assets of any master entity. The Court also concluded that, again as a matter of construction of the Fund’s documentation, an in specie payment from the Fund’s portfolio required the asset to be held by the Fund at the time of the redemption payment date.

Analysis

It will be clear from the above that, when drafting a fund’s offering documentation and articles of association to permit in specie redemptions, consideration needs to be given as to how illiquid assets might be held by the fund in the future. In specie redemption provisions should perhaps contemplate the distribution of assets held not just by the fund itself but also by any master fund; although the usual expectation would be for the relevant master fund assets to be distributed to the feeder before the feeder is required to satisfy a redemption payment. Consideration should also be given to the use of special purpose vehicles (SPVs) which were used by many funds during the financial crisis. In a master-feeder structure, illiquid assets were transferred by the master (either legally or synthetically) to the SPV in return for SPV shares which were then distributed by way of an in kind redemption to the feeder and then, similarly, distributed by the feeder by way of an in kind redemption to investors. The pooling of illiquid assets in an SPV, although not entirely problem-free, addresses many of the issues associated with a fund’s assets being directly transferred to redeeming investors. Since the SPV mechanism relies on the in specie redemption payment provisions within the articles of association, it may be necessary (depending upon their proper construction) for the shares of the SPV to be held by the fund prior to the relevant redemption date.

We certainly think that it is helpful for articles to expressly permit in specie redemptions to be comprised of, among other things, interests in special purpose vehicles holding the actual investment or participations in the actual investment. Actually stating that any such SPV interests may include those acquired by the fund or any master fund after the redemption payment date may however be going too far and may not find favour with investors. As the Court noted in FIA, an investor’s interests might be prejudiced if a fund were able to satisfy an investor’s redemption request by transferring to such investor an asset which the fund did not have while the redeeming shareholder was an investor in the fund.

Another important message to take away from this judgment is that, notwithstanding the Fund’s articles and offering documents, its directors did not have complete discretion to value the Fund’s assets in any manner they saw fit. Consequently, any in specie redemption payment should involve a proper valuation of the assets being distributed.

One question which the Court did not address in FIA was whether certain redemption obligations had been satisfied in specie by way of an assignment of promissory notes.

It is worth noting that in specie redemption provisions invariably provide the right to distribute assets which the fund holds as opposed to notes issued by the fund or shares of the fund. In a decision of the Supreme Court of Bermuda1, Gottex (a fund of funds) brought a claim against a Bermudian fund which had purported to issue a participating note as an in specie redemption payment. The participating note referenced certain of the underlying assets of the Bermudian fund. Gottex challenged the payment on a number of grounds, including that the participating note was not an asset of the fund at the time it was distributed. In that case, it was held that it was not necessary for assets distributed in specie to have been held by the fund at the redemption date. The court ruled however that the participating note could not be described as a distribution because it was not an asset of the fund but rather a derivative instrument created by the fund.

One final point worth noting is that there was no dispute in FIA that the redeeming shareholders were entitled to exercise and had effectively exercised their right to redeem their shares in the Fund. Obviously, the issues discussed above would have been avoided had voluntary redemption rights been suspended in advance of the redemption date. Usually, in such circumstances, suspension of voluntary redemption rights is necessary to enable a fund to remain solvent. This highlights the need, when liquidity issues do arise, for a fund’s directors to consider all of their options very carefully and to take professional advice as to how best to proceed.

A more detailed description of the FIA case can be found on our website: http://www.mourantozannes.com/